REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM
 
 
 
 The
Shareholders and Board of Directors
 Pacific
State Bancorp and Subsidiary
  We
have audited the accompanying consolidated balance sheet of Pacific State
Bancorp and subsidiary as of December 31, 2008 and 2007 and the related
consolidated statements of operations, changes in shareholders' equity,
comprehensive income and cash flows for each of the years in the three-year
period ended December 31, 2008.  These consolidated financial
statements are the responsibility of the Company's management.  Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
  We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audits to obtain reasonable assurance about whether
the consolidated financial statements are free of material
misstatement.  An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the consolidated financial
statements.  An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation.  We believe
that our audits provide a reasonable basis for our opinion.
  In
our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Pacific
State Bancorp and subsidiary as of December 31, 2008 and 2007, and the
consolidated results of their operations and their cash flows for each of the
years in the three-year period ended December 31, 2008, in conformity with
accounting principles generally accepted in the United States of
America.
    /s/
Perry-Smith LLP
    Sacramento,
California
 March
24, 2009
  -1-
  SELECTED
FINANCIAL DATA







The
information set forth below should be read in conjunction with "Management's
Discussion and Analysis of Financial Condition and Results of Operation" and the
Company’s audited consolidated financial statements and notes thereto, included
elsewhere in this report.




(Dollars
      in thousands, except per share data)
                  
                  Year Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004Statements
      of Operations:Total
      Interest Income
                  
                  $
                  27,275
                  
                  
                  $
                  31,242
                  
                  
                  $
                  26,495
                  
                  
                  $
                  18,782
                  
                  
                  $
                  13,509Net
      Interest Income
                  
                  
                  15,035
                  
                  
                  
                  17,400
                  
                  
                  
                  17,307
                  
                  
                  
                  13,536
                  
                  
                  
                  10,451Provision
      for Loan Losses
                  
                  
                  7,001
                  
                  
                  
                  1,425
                  
                  
                  
                  360
                  
                  
                  
                  35
                  
                  
                  
                  504Total
      Non-interest Income
                  
                  
                  (5,268
                  )
                  
                  
                  2,465
                  
                  
                  
                  2,583
                  
                  
                  
                  2,481
                  
                  
                  
                  2,525Total
      Non-interest Expenses
                  
                  
                  13,328
                  
                  
                  
                  10,997
                  
                  
                  
                  10,360
                  
                  
                  
                  9,100
                  
                  
                  
                  7,429(Benefit
      from)Provision for Income Taxes
                  
                  
                  (5,372
                  )
                  
                  
                  2,894
                  
                  
                  
                  3,627
                  
                  
                  
                  2,596
                  
                  
                  
                  1,874Net
      (Loss) Income
                  
                  
                  (5,190
                  )
                  
                  
                  4,549
                  
                  
                  
                  5,543
                  
                  
                  
                  4,286
                  
                  
                  
                  3,169Balance
      Sheets:Total
      Assets
                  
                  
                  421,453
                  
                  
                  
                  431,074
                  
                  
                  
                  386,752
                  
                  
                  
                  309,611
                  
                  
                  
                  254,361Total
      Investments
                  
                  
                  39,738
                  
                  
                  
                  41,352
                  
                  
                  
                  23,107
                  
                  
                  
                  28,539
                  
                  
                  
                  23,582Total
      Loans, net
                  
                  
                  301,945
                  
                  
                  
                  308,458
                  
                  
                  
                  287,318
                  
                  
                  
                  241,556
                  
                  
                  
                  199,535Allowance
      for Loan Losses  (ALL)
                  
                  
                  6,019
                  
                  
                  
                  3,948
                  
                  
                  
                  2,478
                  
                  
                  
                  2,356
                  
                  
                  
                  2,214Total
      Deposits
                  
                  
                  340,980
                  
                  
                  
                  341,821
                  
                  
                  
                  340,996
                  
                  
                  
                  273,074
                  
                  
                  
                  223,761Subordinated
      Debentures
                  
                  
                  8,764
                  
                  
                  
                  8,764
                  
                  
                  
                  8,764
                  
                  
                  
                  8,764
                  
                  
                  
                  8,764Shareholders'
      Equity
                  
                  
                  27,284
                  
                  
                  
                  34,036
                  
                  
                  
                  29,059
                  
                  
                  
                  21,373
                  
                  
                  
                  16,830Performance
      Ratios:(Loss)
      Return on Average Assets
                  
                  
                  (1.20
                  )%
                  
                  
                  1.13
                  %
                  
                  
                  1.67
                  %
                  
                  
                  1.53
                  %
                  
                  
                  1.37
                  %(Loss)
      Return on Average Equity
                  
                  
                  (14.95
                  )%
                  
                  
                  14.22
                  %
                  
                  
                  22.91
                  %
                  
                  
                  22.98
                  %
                  
                  
                  21.64
                  %Average
      Equity to Average Assets
                  
                  
                  8.00
                  %
                  
                  
                  7.95
                  %
                  
                  
                  7.30
                  %
                  
                  
                  6.65
                  %
                  
                  
                  6.34
                  %Tier
      1 Risk-Based Capital
                  
                  
                  10.25
                  %
                  
                  
                  11.40
                  %
                  
                  
                  10.65
                  %
                  
                  
                  10.44
                  %
                  
                  
                  10.10
                  %Total
      Risk-Based Capital
                  
                  
                  11.50
                  %
                  
                  
                  12.60
                  %
                  
                  
                  11.83
                  %
                  
                  
                  11.88
                  %
                  
                  
                  12.60
                  %Net
      Interest Margin
                  
                  
                  3.84
                  %
                  
                  
                  4.79
                  %
                  
                  
                  5.76
                  %
                  
                  
                  5.41
                  %
                  
                  
                  5.14
                  %Average
      Earning Assets to Average Total Assets
                  
                  
                  90.40
                  %
                  
                  
                  90.31
                  %
                  
                  
                  93.33
                  %
                  
                  
                  89.22
                  %
                  
                  
                  88.18
                  %Nonperforming
      Assets to Total Assets
                  
                  
                  5.59
                  %
                  
                  
                  0.10
                  %
                  
                  
                  --
                  
                  
                  
                  --
                  
                  
                  
                  --ALL
      to Total Loans
                  
                  
                  1.95
                  %
                  
                  
                  1.26
                  %
                  
                  
                  0.86
                  %
                  
                  
                  0.98
                  %
                  
                  
                  1.10
                  %Nonperforming
      Loans to ALL
                  
                  
                  391.43
                  %
                  
                  
                  10.94
                  %
                  
                  
                  --
                  
                  
                  
                  --
                  
                  
                  
                  --Share
      Data:Common
      Shares Outstanding
                  
                  
                  3,718,598
                  
                  
                  
                  3,707,698
                  
                  
                  
                  3,665,968
                  
                  
                  
                  3,517,113
                  
                  
                  
                  3,448,042Book
      Value Per Share
                  
                  $
                  7.34
                  
                  
                  $
                  9.19
                  
                  
                  $
                  7.94
                  
                  
                  $
                  6.08
                  
                  
                  $
                  4.88Basic
      (Loss) Earnings Per Share
                  
                  $
                  (1.40
                  )
                  
                  $
                  1.23
                  
                  
                  $
                  1.57
                  
                  
                  $
                  1.23
                  
                  
                  $
                  0.92Diluted
      Earnings Per Share
                  
                  $
                  (1.40
                  )
                  
                  $
                  1.14
                  
                  
                  $
                  1.41
                  
                  
                  $
                  1.10
                  
                  
                  $
                  0.84


-2-




PACIFIC
STATE BANCORP AND SUBSIDIARY


CONSOLIDATED
BALANCE SHEET


December
31, 2008 and 2007


(In
thousands, except share amounts)





2008
            
            
            2007ASSETSCash
      and due from banks
            
            $
            16,700
            
            
            $
            13,794Federal
      funds sold
            
            
            21,811
            
            
            
            31,880Total
      cash and cash equivalents
            
            
            38,511
            
            
            
            45,674Interest-bearing
      deposits in other banks
            
            
            -
            
            
            
            3,000Investment
      securities (Notes 3 and 7)
            
            
            39,738
            
            
            
            41,352Loans,
      less allowance for loan losses of $6,019 in 2008 and $3,948 in 2007 (Notes
      4, 10 and 13)
            
            
            301,945
            
            
            
            308,458Premises
      and equipment, net (Note 5)
            
            
            16,811
            
            
            
            14,269Other
      real estate
            
            
            2,029
            
            
            
            -Company
      owned life insurance (Note 14)
            
            
            6,751
            
            
            
            8,025Accrued
      interest receivable and other assets (Note 9)
            
            
            15,668
            
            
            
            10,296Total
      assets
            
            $
            421,453
            
            
            $
            431,074LIABILITIES
      ANDSHAREHOLDERS'
      EQUITYDeposits:Non-interest
      bearing
            
            $
            69,874
            
            
            $
            67,071Interest
      bearing (Note 6)
            
            
            271,106
            
            
            
            274,750Total
      deposits
            
            
            340,980
            
            
            
            341,821Other
      borrowings (Note 7)
            
            
            40,000
            
            
            
            40,000Subordinated
      debentures (Note 8)
            
            
            8,764
            
            
            
            8,764Accrued
      interest payable and other liabilities
            
            
            4,425
            
            
            
            6,453Total
      liabilities
            
            
            394,169
            
            
            
            397,038Shareholders'
      equity (Note 11):Preferred
      stock - 2,000,000 shares authorized; none issued or
      outstanding
            
            
            -
            
            
            
            -Common
      stock - no par value; 24,000,000 shares authorized; issued and outstanding
      –3,718,598 shares in 2008 and 3,707,698 shares in 2007
            
            
            10,767
            
            
            
            10,418Retained
      earnings
            
            
            18,814
            
            
            
            24,004Accumulated
      other comprehensive loss, net of taxes (Notes 3 and 15)
            
            
            (2,297
            )
            
            
            (386
            )Total
      shareholders' equity
            
            
            27,284
            
            
            
            34,036Total
      liabilities and shareholders' equity
            
            $
            421,453
            
            
            $
            431,074




The
accompanying notes are an integral


part of
these consolidated financial statements


-3-


PACIFIC
STATE BANCORP AND SUBSIDIARY


CONSOLIDATED
STATEMENT OF OPERATIONS


For
the Years Ended December 31, 2008, 2007 and 2006


(In
thousands, except per share amounts)





2008
            
            
            2007
            
            
            2006Interest
      income:Interest
      and fees on loans
            
            $
            24,565
            
            
            $
            27,902
            
            
            $
            24,901Interest
      on Federal funds sold
            
            
            376
            
            
            
            1,285
            
            
            
            273Interest
      and dividends on investment securities:Taxable
            
            
            2,095
            
            
            
            1,843
            
            
            
            1,093Exempt
      from Federal income taxes
            
            
            150
            
            
            
            134
            
            
            
            158Dividends
            
            
            89
            
            
            
            78
            
            
            
            70Total
      interest income
            
            
            27,275
            
            
            
            31,242
            
            
            
            26,495Interest
      expense:Interest
      on deposits (Note 6)
            
            
            10,425
            
            
            
            12,844
            
            
            
            8,102Interest
      on borrowings (Note 7)
            
            
            1,351
            
            
            
            296
            
            
            
            376Interest
      on subordinated debentures (Note 8)
            
            
            464
            
            
            
            702
            
            
            
            710Total
      interest expense
            
            
            12,240
            
            
            
            13,842
            
            
            
            9,188Net
      interest income before provision for loan losses
            
            
            15,035
            
            
            
            17,400
            
            
            
            17,307Provision
      for loan losses (Note 4)
            
            
            7,001
            
            
            
            1,425
            
            
            
            360Net
      interest income after provision for loan losses
            
            
            8,034
            
            
            
            15,975
            
            
            
            16,947Non-interest
      income:Service
      charges
            
            
            823
            
            
            
            889
            
            
            
            864Gain
      on sale of loans
            
            
            188
            
            
            
            150
            
            
            
            294Gain
      on sale of assets
            
            
            471
            
            
            
            -
            
            
            
            -Gain
      on death benefit from company owned life insurance
            
            
            2,574
            
            
            
            -
            
            
            
            -Other
      income
            
            
            890
            
            
            
            1,426
            
            
            
            1,425Other
      than temporary impairment charge (Note 3)
            
            
            (8,923
            )
            
            
            -
            
            
            
            -Loss
      on sale of securities (Note 3)
            
            
            (1,291
            )
            
            
            -
            
            
            
            -Total
      non-interest income
            
            
            (5,268
            )
            
            
            2,465
            
            
            
            2,583Non-interest
      expenses:Salaries
      and employee benefits (Note 14)
            
            
            5,546
            
            
            
            5,336
            
            
            
            5,479Occupancy
      (Notes 5 and 10)
            
            
            1,251
            
            
            
            1,180
            
            
            
            980Furniture
      and equipment (Notes 5 and 10)
            
            
            1,032
            
            
            
            708
            
            
            
            672Other
      expenses (Note 12)
            
            
            5,499
            
            
            
            3,773
            
            
            
            3,229Total
      non-interest expenses
            
            
            13,328
            
            
            
            10,997
            
            
            
            10,360(Loss)
      income before (benefit from) provision for income taxes
            
            
            (10,562
            )
            
            
            7,443
            
            
            
            9,170(Benefit
      from) provision for income taxes (Note 9)
            
            
            (5,372
            )
            
            
            2,894
            
            
            
            3,627Net
      (loss) income
            
            $
            (5,190
            )
            
            $
            4,549
            
            
            $
            5,543Basic
      (loss) earnings per share (Note 11)
            
            $
            (1.40
            )
            
            $
            1.23
            
            
            $
            1.57Diluted
      (loss) earnings per share (Note 11)
            
            $
            (1.40
            )
            
            $
            1.14
            
            
            $
            1.41




The
accompanying notes are an integral


part of
these consolidated financial statements


-4-


PACIFIC
STATE BANCORP AND SUBSIDIARY


CONSOLIDATED
STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY


For
the Years Ended December 31, 2008, 2007 and 2006


(In
thousands, except share amounts)





Common
      Stock
            
            
            
            
            
            Accumulated
      Other
              Compre-
              hensive
            
            
            TotalShares
            
            
            Amount
            
            
            Retained
              Earnings
            
            
            Loss
      (Net
              of
      Taxes)
            
            
            Shareholders'
              EquityBalance,
      January 1, 2006
            
            
            3,517,113
            
            
            $
            7,556
            
            
            $
            13,912
            
            
            $
            (95
            )
            
            $
            21,373Net
      income
            
            
            
            
            
            
            
            
            
            
            5,543
            
            
            
            
            
            
            
            5,543Net
      change in unrealized gains (losses) on available-for-sale investment
      securities, net of tax
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            48
            
            
            
            48Stock-based
      compensation expense
            
            
            
            
            
            
            229
            
            
            
            
            
            
            
            
            
            
            
            229Stock
      options exercised and related tax benefit (Note 11)
            
            
            135,421
            
            
            
            1,616
            
            
            
            
            
            
            
            
            
            
            
            1,616Proceeds
      from issuance of stock
            
            
            13,434
            
            
            
            250
            
            
            
            
            
            
            
            
            
            
            
            250Balance,
      December 31, 2006
            
            
            3,665,968
            
            
            
            9,651
            
            
            
            19,455
            
            
            
            (47
            )
            
            
            29,059Net
      income
            
            
            
            
            
            
            
            
            
            
            4,549
            
            
            
            
            
            
            
            4,549Net
      change in unrealized gains (losses) on available-for-sale investment
      securities, net of tax
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (339
            )
            
            
            (339
            )Stock-based
      compensation expense
            
            
            
            
            
            
            309
            
            
            
            
            
            
            
            
            
            
            
            309Stock
      options exercised and related tax benefit (Note 11)
            
            
            41,730
            
            
            
            458
            
            
            
            
            
            
            
            
            
            
            
            458Balance,
      December 31, 2007
            
            
            3,707,698
            
            
            
            10,418
            
            
            
            24,004
            
            
            
            (386
            )
            
            
            34,036Net
      loss
            
            
            
            
            
            
            
            
            
            
            (5,190
            )
            
            
            
            
            
            
            (5,190
            )Net
      change in unrealized gains (losses) on available-for-sale investment
      securities, net of tax (Note 3)
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (1,911
            )
            
            
            (1,911
            )Stock-based
      compensation expense
            
            
            
            
            
            
            270
            
            
            
            
            
            
            
            
            
            
            
            270Stock
      options exercised and related tax benefit (Note 11)
            
            
            10,900
            
            
            
            79
            
            
            
            
            
            
            
            
            
            
            
            79Balance,
      December 31, 2008
            
            
            3,718,598
            
            
            $
            10,767
            
            
            $
            18,814
            
            
            $
            (2,297
            )
            
            $
            27,284





The
accompanying notes are an integral


part of
these consolidated financial statements




-5-




PACIFIC
STATE BANCORP AND SUBSIDIARY


CONSOLIDATED
STATEMENT OF COMPREHENSIVE  (LOSS) INCOME


For
the Years Ended December 31, 2008, 2007 and 2006


(In
thousands)





2008
            
            
            2007
            
            
            2006Net
      (loss) income
            
            $
            (5,190
            )
            
            $
            4,549
            
            
            $
            5,543Other
      comprehensive (loss) income:Unrealized
      holding (losses) gains arising during the year, net of tax
            
            
            (1,911
            )
            
            
            (339
            )
            
            
            48Reclassification
      adjustment for unrealized loss and other than temporary impairment charge
      included in net loss, net of tax
            
            
            6,011
            
            
            
            -
            
            
            
            -Total
      comprehensive (loss) income
            
            $
            (1,090
            )
            
            $
            4,210
            
            
            $
            5,591




The
accompanying notes are an integral


part of
these consolidated financial statements


-6-


PACIFIC
STATE BANCORP AND SUBSIDIARY


CONSOLIDATED
STATEMENT OF CASH FLOWS


For
the Years Ended December 31, 2008, 2007 and 2006


(In
thousands)





2008
            
            
            2007
            
            
            2006Cash
      flows from operating activities:Net
      (loss) income
            
            $
            (5,190
            )
            
            $
            4,549
            
            
            $
            5,543Provision
      for loan losses
            
            
            7,001
            
            
            
            1,425
            
            
            
            360Net
      decrease (increase) in deferred loan origination costs
            
            
            65
            
            
            
            (168
            )
            
            
            173Depreciation,
      amortization and accretion
            
            
            503
            
            
            
            93
            
            
            
            404Gain
      on sale of loans
            
            
            (188
            )
            
            
            (150
            )
            
            
            (294
            )Loss
      on sale of premises or equipment
            
            
            -
            
            
            
            57
            
            
            
            -Stock-based
      compensation expense
            
            
            270
            
            
            
            309
            
            
            
            229Tax
      benefit from exercise of stock options
            
            
            (4
            )
            
            
            (223
            )
            
            
            (736
            )Company
      owned life insurance earnings
            
            
            (318
            )
            
            
            (246
            )
            
            
            (208
            )Gain
      on death benefit from company owned life insurance
            
            
            (2,574
            )
            
            
            -
            
            
            
            -Decrease
      (increase) in accrued interest receivable and other assets
            
            
            402
            
            
            
            (651
            )
            
            
            (392
            )Loss
      on sale of securities
            
            
            1,291
            
            
            
            -
            
            
            
            -Other
      than temporary impairment charge
            
            
            8,923
            
            
            
            -
            
            
            
            -(Benefit)
      provision for deferred income taxes
            
            
            (5,301
            )
            
            
            (755
            )
            
            
            12(Decrease)
      increase  in accrued interestpayable
      and other liabilities
            
            
            (2,028
            )
            
            
            3,420
            
            
            
            418Net
      cash provided by operating activities
            
            
            2,852
            
            
            
            7,660
            
            
            
            5,509Cash
      flows from investing activities:Decrease
      (increase) in interest bearing deposits at other banks
            
            
            3,000
            
            
            
            (3,000
            )
            
            
            -Purchases
      of available-for-sale investment securities
            
            
            (48,361
            )
            
            
            (53,022
            )
            
            
            (11,257
            )Proceeds
      from the sale of available-for-sale securities
            
            
            13,635
            
            
            
            -
            
            
            
            -Proceeds
      from matured and called available-for-sale investment
      securities
            
            
            22,735
            
            
            
            33,805
            
            
            
            16,364Proceeds
      from principal repayments from available-for-sale government-guaranteed
      mortgage-backed securities
            
            
            1,261
            
            
            
            1,068
            
            
            
            722Proceeds
      from principal repayments from held-to-maturity government-guarantee
      mortgage-backed securities
            
            
            26
            
            
            
            5
            
            
            
            23Purchase
      of FRB and FHLB stock
            
            
            (14
            )
            
            
            (831
            )
            
            
            (180
            )Net
      increase in loans
            
            
            (4,210
            )
            
            
            (22,247
            )
            
            
            (45,786
            )Redemption
      (purchase) of company owned life insurance
            
            
            4,166
            
            
            
            (1,700
            )
            
            
            (1,460
            )Purchases
      of premises and equipment
            
            
            (5,397
            )
            
            
            (3,082
            )
            
            
            (3,128
            )Net
      cash used in investing activities
            
            
            (9,253
            )
            
            
            (48,984
            )
            
            
            (44,702
            )Cash
      flows from financing activities:Net
      increase (decrease) in demand, interest-bearing and savings
      deposits
            
            
            7,746
            
            
            
            (21,893
            )
            
            
            (12,262
            )Net
      (decrease) increase in time deposits
            
            
            (8,587
            )
            
            
            22,718
            
            
            
            80,184Proceeds
      from exercise of stock options
            
            
            75
            
            
            
            235
            
            
            
            880Excess
      tax benefit from exercise of stock options
            
            
            4
            
            
            
            223
            
            
            
            736Proceeds
      from stock issuance
            
            
            -
            
            
            
            -
            
            
            
            250Net
      increase in other borrowings
            
            
            -
            
            
            
            35,100
            
            
            
            900Net
      cash (used in) provided by financing activities
            
            
            (762
            )
            
            
            36,383
            
            
            
            70,688(Decrease)
      increase in cash and cash equivalents
            
            
            (7,163
            )
            
            
            (4,941
            )
            
            
            31,495Cash
      and cash equivalents at beginning of period
            
            
            45,674
            
            
            
            50,615
            
            
            
            19,120Cash
      and cash equivalents at end of period
            
            $
            38,511
            
            
            $
            45,674
            
            
            $
            50,615Supplemental
      disclosure of cash flow information:Cash
      paid during the year for:Interest
      expense
            
            $
            12,565
            
            
            $
            13,048
            
            
            $
            10,475Income
      taxes
            
            $
            925
            
            
            $
            2,500
            
            
            $
            3,805Non-cash
      investing activities:Net
      unrealized loss (gain) on available-for-sale investment
      securities
            
            $
            3,253
            
            
            $
            (565
            )
            
            $
            78





The
accompanying notes are an integral


part of
these consolidated financial statements


-7-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




NOTE
1. NATURE OF OPERATIONS


On June
24, 2002, Pacific State Bancorp ("Bancorp") commenced operations as a bank
holding company by acquiring all of the outstanding shares of Pacific State Bank
("Bank") in a one bank holding company reorganization.  This corporate
structure gives Bancorp and the Bank greater flexibility in terms of operation,
expansion, and diversification.


Pacific
State Bancorp's subsidiaries include the Bank, Pacific State Statutory Trust II
and Pacific State Statutory Trust III.  Pacific State Statutory
Trust II and Pacific State Statutory Trust III are unconsolidated Delaware
statutory business trusts formed in March 2004 and June 2007, respectively, for
the exclusive purpose of issuing and selling trust preferred securities and
holding subordinated debentures issued by Bancorp.  The proceeds from
the issuance of subordinated debentures in 2004 were utilized by Bancorp to
provide capital to the Bank and for general corporate purposes.  The
proceeds from the issuance of subordinated debenture in 2007 were utilized to
retire subordinated debentures issued in 2002.


The Bank
commenced operations in 1987 and is a California state-chartered member bank of
the Federal Reserve System.  The Bank operates nine branches in
California, including two branches in Stockton and branches in Modesto,
Groveland, Arnold, Angels Camp, Tracy, Lodi and Hayward.  The Bank's
primary source of revenue is providing loans to customers who are predominately
small and middle-market businesses and individuals.




NOTE
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES


The
accounting and reporting policies of Pacific State Bancorp and its subsidiary
(collectively, the "Company") conform with accounting principles generally
accepted in the United States and prevailing practice within the banking
industry.  The more significant of these policies applied in the
preparation of the accompanying consolidated financial statements are discussed
below.





PRINCIPLES
OF CONSOLIDATION


The
accompanying consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiary, Pacific State
Bank.  Significant intercompany transactions and balances have been
eliminated in consolidation.  For financial reporting purposes, the
Company's investment in Pacific State Statutory Trusts II and III ("Trusts") are
accounted for under the equity method and are included in accrued interest
receivable and other assets in the consolidated balance sheet.  The
subordinated debentures issued and guaranteed by the Company and held by the
Trusts are included as subordinated debentures in the consolidated balance
sheet.





SEGMENT
INFORMATION


Management
has determined that because all of the banking products and services offered by
the Company are available in each branch of the Bank, all branches are located
within the same economic environment and management does not allocate resources
based on the performance of different lending or transaction activities, it is
appropriate to aggregate the Bank branches and report them as a single operating
segment.  No customer accounts for more than 10 percent of revenues
for the Company or the Bank.





USE
OF ESTIMATES


The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions.  These estimates and assumptions affect the
reported amounts of assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period.  Actual results could differ from these
estimates.





RECLASSIFICATIONS


Certain
reclassifications have been made to prior years' balances to conform to
classifications used in 2008.





CASH
AND CASH EQUIVALENTS


For the
purpose of the statement of cash flows, cash, due from banks and Federal funds
sold are considered to be cash equivalents.  Generally, Federal funds
are sold for one-day periods.





INVESTMENT
SECURITIES


Investment
securities are classified into the following categories:





·  Available-for-sale
securities, reported at fair value, with unrealized gains and losses excluded
from earnings and reported, net of taxes, as accumulated other comprehensive
income (loss) within shareholders' equity.


·  Held-to-maturity
securities, which management has the positive intent and ability to hold to
maturity, reported at amortized cost, adjusted for the accretion of discounts
and amortization of premiums.





Management
determines the appropriate classification of its investments at the time of
purchase and may only change the classification in certain limited
circumstances.  The Company did not have any investments classified as
trading at December 31, 2008 or 2007.  All transfers between
categories are accounted for at fair value. There were no transfers between
categories in 2008 or 2007.


Gains or
losses on the sale of investment securities are computed on the specific
identification method.  Interest earned on investment securities is
reported in interest income, net of applicable adjustments for accretion of
discounts and amortization of premiums.


Investment
securities are evaluated for impairment on at least a quarterly basis and more
frequently when economic or market conditions warrant such an evaluation to
determine whether a decline in their value is other than
temporary.  Management utilizes criteria such as the magnitude and
duration of the decline and the intent and ability of the Company to retain its
investment in the securities for a period of time sufficient to allow for an
anticipated recovery in fair value, in addition to the reasons underlying the
decline, to determine whether the loss in value is other than
temporary.  The term "other than temporary" is not intended to
indicate that the decline is permanent, but indicates that the prospects for a
near-term recovery of value is not necessarily favorable, or that there is a
lack of evidence to support a realizable value equal to or greater than the
carrying value of the investment.  Once a decline in value is
determined to be other than temporary, the value of the security is reduced and
a corresponding charge to earnings is recognized.


As a
member of the Federal Reserve System, the Federal Home Loan Bank System and the
Farmer Mac Home Administration System, the Bank is required to maintain an
investment in restricted capital stock of each system.  These
investments are carried at cost and are redeemable at par and are included in
accrued interest receivable and other assets in the consolidated balance
sheet.





LOANS


Loans are
stated at principal balances outstanding.  Interest is accrued daily
based upon outstanding loan balances.  However, when, in the opinion
of management, loans are considered to be impaired and the future collectability
of interest and principal is in serious doubt, loans are placed on nonaccrual
status and the accrual of interest income is suspended.  Any interest
accrued but unpaid is charged against income.  Payments received are
applied to reduce principal to the extent necessary to ensure
collection.  Subsequent payments on these loans, or payments received
on nonaccrual loans for which the ultimate collectability of principal is not in
doubt, are applied first to earned but unpaid interest and then to
principal.


An
impaired loan is measured based on the present value of expected future cash
flows discounted at the loan's effective interest rate or, as a practical
matter, at the loan's observable market price or the fair value of collateral if
the loan is collateral dependent.  A loan is considered impaired when,
based on current information and events, it is probable that the Company will be
unable to collect all amounts due (including both principal and interest) in
accordance with the contractual terms of the loan agreement.  Interest
income on impaired loans, if appropriate, is recognized on a cash
basis.


Loan
origination fees, commitment fees, direct loan origination costs and purchase
premiums and discounts on loans are deferred and recognized as an adjustment of
yield, and amortized to interest income over the contractual term of the
loan.  The unamortized balance of deferred fees and costs is reported
as a component of net loans.


The
Company may purchase loans or acquire loans through a business combination for
which differences exist between the contractual cash flows and the cash flows
expected to be collected due, at least in part, to credit
quality.  When the Company acquires such loans, the yield that may be
accreted (accretable yield) is limited to the excess of the Company’s estimate
of undiscounted cash flows expected to be collected over the Company’s initial
investment in the loan.  The excess of contractual cash flows over
cash flows expected to be collected may not be recognized as an adjustment to
yield, loss, or a valuation allowance.  Subsequent increases in cash
flows expected to be collected generally should be recognized prospectively
through adjustment of the loan’s yield over its remaining
life.  Decreases in cash flows expected to be collected should be
recognized as an impairment.  The Company may not "carry over" or
create a valuation allowance in the initial accounting for loans acquired under
these circumstances.  At December 31, 2008 and 2007, there were
no such loans being accounted for under this policy.




-8-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




LOAN
SALES AND SERVICING


The
Company accounts for the transfer and servicing of financial assets based on the
financial and servicing assets it controls and liabilities it has incurred,
derecognizes financial assets when control has been surrendered and derecognizes
liabilities when extinguished.





Government
Guaranteed Loans


Included
in the loan portfolio are loans which are 75% to 90% guaranteed by the Small
Business Administration (SBA), Farmer Mac and USDA Business and
Industry.  The guaranteed portion of these loans may be sold to a
third party, with the Company retaining the unguaranteed portion.  The
Company generally receives a premium in excess of the adjusted carrying value of
the loan at the time of sale.  The Company may be required to refund a
portion of the sales premium if the borrower defaults or prepays within ninety
days of the settlement date.  At December 31, 2008, there were no
premiums subject to these recourse provisions.


The
Company's investment in the loan is allocated between the retained portion of
the loan, the servicing asset (liability) and the sold portion of the loan based
on their relative fair values on the date the loan is sold.  The gain
on the sold portion of the loan is recognized as income at the time of
sale.  The carrying value of the retained portion of the loan is
discounted based on the estimated value of a comparable non-guaranteed
loan.  The servicing asset (liability) is recognized and amortized
over the estimated life of the related loan.  Significant future
prepayments of these loans will result in the recognition of additional
amortization of related servicing assets (liabilities).


The
Company serviced government-guaranteed loans for others totaling $53,112,000 and
$47,714,000 as of December 31, 2008 and 2007 respectively.





Servicing
Rights


Servicing
rights acquired through 1) a purchase or 2) the origination of loans which are
sold with servicing rights retained are recognized as separate assets or
liabilities.  Servicing assets or liabilities are recorded at the
difference between the contractual servicing fees and adequate compensation for
performing the servicing, and are subsequently amortized in proportion to and
over the period of the related net servicing income or
expense.  Servicing assets are periodically evaluated for
impairment.  Servicing rights were not significant at
December 31, 2008 and 2007.





ALLOWANCE
FOR LOAN LOSSES


The
allowance for loan losses is maintained to provide for losses related to
impaired loans and other losses that can be expected to occur in the normal
course of business.  The determination of the allowance is based on
estimates made by management, to include consideration of the character of the
loan portfolio, specifically identified problem loans, potential losses inherent
in the portfolio taken as whole and economic conditions in the Company's service
area.


Classified
loans and loans determined to be impaired are individually evaluated by
management for specific risk of loss.  In addition, reserve factors
are assigned to currently performing loans based on management's assessment of
the following for each identified loan type: (1) inherent credit risk,
(2) historical losses and, (3) where the Company has not experienced
losses, the loss experience of peer banks.  These estimates are
particularly susceptible to changes in the economic environment and market
conditions.


The
Bank's Loan Committee reviews the adequacy of the allowance for loan losses at
least quarterly, to include consideration of the relative risks in the portfolio
and current economic conditions and other factors.  The allowance is
adjusted based on that review if, in the judgment of the Loan Committee and
management, changes are warranted.


This
allowance is established through a provision for loan losses which is charged to
expense.  Additions to the allowance are expected to maintain the
adequacy of the total allowance after net charge-offs and loan
growth.  The allowance for loan losses at December 31, 2008 and 2007,
respectively, reflects management's estimate of probable losses in the
portfolio.





Allowance
for Losses Related to Undisbursed Loan and Lease Commitments


The Bank
maintains a separate allowance for losses related to undisbursed loan and lease
commitments. Management estimates the amount of probable losses by applying the
loss factors used in the allowance for loan and lease loss methodology to an
estimate of the expected usage of undisbursed commitments for each loan or lease
type. The allowance totaled $222,000 at December 31, 2008 and 2007, and is
included in accrued interest payable and other liabilities on the consolidated
balance sheet.




-9-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




OTHER
REAL ESTATE


Other
real estate includes real estate acquired in full or partial settlement of loan
obligations.  When property is acquired, any excess of the Company's
recorded investment in the loan balance and accrued interest income over the
estimated fair market value of the property, net of estimated selling costs, is
charged against the allowance for loan losses.  A valuation allowance
for losses on other real estate is maintained to provide for temporary declines
in value.  The allowance is established through a provision for losses
on other real estate which is included in other expenses.  Subsequent
gains or losses on sales or writedowns resulting from permanent impairments are
recorded in other income or expenses as incurred.  At December 31,
2008 the Company has $2,029,000 in other real estate and no other real estate at
December 31 2007.




PREMISES
AND EQUIPMENT


Premises
and equipment are carried at cost.  Depreciation is determined using
the straight-line method over the estimated useful lives of the related
assets.  The useful lives of premises are estimated to be ten to
thirty-nine years.  The useful lives of furniture, fixtures and
equipment are estimated to be three to fifteen years.  Leasehold
improvements are amortized over the life of the asset or the life of the related
lease, whichever is shorter.  When assets are sold or otherwise
disposed of, the cost and related accumulated depreciation and amortization are
removed from the accounts, and any resulting gain or loss is recognized in
income for the period.  The cost of maintenance and repairs is charged
to expense as incurred.


The
Company evaluates premises and equipment for financial impairment as events or
changes in circumstances indicate that the carrying amount of such assets may
not be fully recoverable.




GOODWILL
AND INTANGIBLE ASSETS


As a
result of the Company's 2002 acquisition of the Stockton branch of California
Bank & Trust, the Company recognized a core deposit intangible asset of
$448,000 and goodwill of $718,000.  The valuation of the core deposit
intangible was based on the estimated fair value of deposits acquired and is
amortized over a period of ten years.  The current balance of the core
deposit intangible of $27,000 is included in accrued interest receivable and
other assets in the consolidated balance sheet.  Goodwill is not
amortized, but is measured along with the core deposit intangible for
impairment.  At December 31, 2008 and 2007, no impairment of the core
deposit intangible or goodwill has been recognized in the Company’s consolidated
financial statements.





INCOME
TAXES


The
Company files its income taxes on a consolidated basis with its
subsidiary.  The allocation of income tax expense (benefit) represents
each entity’s proportionate share of the consolidated provision for income
taxes.


Deferred
tax assets and liabilities are recognized for the tax consequences of temporary
differences between the reported amounts of assets and liabilities and their tax
basis.  Deferred tax assets and liabilities are adjusted for the
effects of changes in tax laws and rates on the date of enactment.  On
the consolidated balance sheet, net deferred tax assets are included in accrued
interest receivable and other assets.


On
January 1, 2007, the Company adopted Financial Accounting Standards Board
("FASB") Interpretation No. 48, Accounting for Uncertainty in Income
Taxes ("FIN 48").  FIN 48 clarifies the accounting
for uncertainty in income taxes recognized in an enterprise's financial
statements in accordance with FASB Statement No. 109, Accounting for Income
Taxes.  FIN 48 prescribes a recognition threshold and
measurement standard for the financial statement recognition and measurement of
an income tax position taken or expected to be taken in a tax
return.  In addition, FIN 48 provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure and transition.


The
provisions of FIN 48 have been applied to all tax positions of the Company as of
January 1, 2007.  Only tax positions that met the more-likely-than-not
recognition threshold on January 1, 2007 were recognized or continue to be
recognized.  The Company previously recognized income tax positions
based on management's estimate of whether it was reasonably possible that a
liability has been incurred for unrecognized income tax benefits by applying
FASB Statement No. 5, Accounting for
Contingencies.  The adoption of FIN 48 did not have a
material impact on the Company’s financial position, results of operations or
cash flows.


The
Company recognizes interest accrued and penalties related to unrecognized tax
benefits, if any in tax expense.





-10-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




EARNINGS
(LOSS) PER SHARE


Basic
earnings (loss) per share (EPS), which excludes dilution, is computed by
dividing income available to common shareholders by the weighted-average number
of common shares outstanding for the period.  Diluted EPS reflects the
potential dilution that could occur if securities or other contracts to issue
common stock, such as stock options, result in the issuance of common stock
which shares in the earnings of the Company.  The Company had a net
loss for 2008, therefore all stock options are antidilutive.  All data
with respect to computing earnings per share is retroactively adjusted to
reflect stock splits and dividends and the treasury stock method is applied to
determine the dilutive effect of stock options in computing diluted
EPS.





STOCK-BASED
COMPENSATION


At
December 31, 2008, the Company had one shareholder approved stock-based
compensation plan which is described more fully in Note 11.  The
Company accounts for its stock based compensation plan in accordance with FASB
Statement No. 123(R), Share-Based Payment (SFAS
123(R)),using the modified prospective transition method.  Under that
transition method, compensation cost recognized in fiscal years 2006, 2007 and
2008 includes: (a) compensation cost for all share-based payments vesting during
2006, 2007 and 2008 that were granted prior to, but not yet vested as of January
1, 2006, based on the grant-date fair value estimated in accordance with the
original provisions of SFAS 123, and (b) compensation cost for all share-based
payments vesting during 2006, 2007 and 2008 that were granted subsequent to
January 1, 2006, based on the grant-date fair value estimated in accordance with
the provisions of SFAS 123(R).  For further information on grants and
vesting please refer to Note 11. The Company applied the alternative transition
method in calculating its pool of excess tax benefits available to absorb future
tax deficiencies as provided by FSP FAS 123(R)-3, Transition Election Related to
Accounting for the Tax Effects of Share-Based Payment Awards.Compensation cost is recognized net of estimated forfeitures. Results for
prior periods have not been restated.


As a
result of applying SFAS 123(R), the Company recorded an expense of $270,000 or
$203,000 after tax in 2008, $309,000 or $239,000 after tax in 2007 and $229,000
or $133,000 after tax in 2006.





Determining
Fair Value


The
Company bases the fair value of the options previously granted on the date of
grant using a Black-Scholes-Merton option pricing model that uses assumptions
based on expected option life, the level of expected stock volatility and the
risk-free interest rate.  Stock volatility is based on the historical
volatility of the Company's stock. The risk-free rate is based on the U.S.
Treasury yield curve and the expected term of the options. The expected term of
the options represents the period that the Company's share-based awards are
expected to be outstanding based on the terms of the optionee’s employment
agreement and position within the Company, previous option activity, the number
of shares currently owned and the expected time of when those options would be
exercised. The Company has not paid cash dividends. The Company estimates the
forfeiture rate in calculating the compensation expense to be
insignificant.  The Company did not grant any stock options in
2008.  In 2007 the Company granted 30,000 stock options using a risk
free rate of 4.98%, volatility rate of 34.79% and forfeiture rate of
2%.  This resulted in a fair market value under the
Black-Scholes-Merton model of $9.22 per option.





TRANSACTION
ACCOUNT GUARANTEE PROGRAM


The Bank
is participating in the FDIC's Transaction Account Guarantee
Program.  Under this program, through December 31, 2009, all
noninterest-bearing transaction accounts are fully guaranteed by the FDIC for
the entire amount in the account and the Bank is assessed an annual fee of 10
basis points for all deposit amounts exceeding the existing deposit insurance
limit of $250,000.  Coverage under the Transaction Account Guarantee
Program is in addition to and separate from the coverage available under the
FDIC's general deposit insurance rules.




-11-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


NEW
FINANCIAL ACCOUNTING STANDARDS





Fair
Value Measurements


In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements,
which defines and establishes a framework for measuring fair value used in FASB
pronouncements issued by FASB that require or permit fair value
measurement.  This statement expands disclosures using fair value to
measure assets and liabilities in interim and annual periods subsequent to the
period of initial recognition.  SFAS No. 157 is effective for
financial statements issued for fiscal years beginning after November 15,
2007, and interim periods within those years.  Management adopted this
statement on January 1, 2008.  The impact of adoption was not
material to the Company's financial condition or results of
operations.  See Note 16 – Fair Value Measurements.





Determining
the Fair Value of a Financial Asset When the Market for That Asset Is Not
Active


In
October 2008, the Financial Accounting Standards Board (FASB) issued FASB Staff
Position (FSP) Financial Accounting Standard 157-3, Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not
Active.  The FSP clarifies the application of FASB Statement
No. 157, Fair Value
Measurements and provides an example to illustrate key considerations in
determining the fair value of a financial asset when the market for that
financial asset is not active.  The FSP was effective immediately, and
includes prior period financial statements that have not yet been
issued.  The Company is subject to the provisions of the FSP effective
immediately; however, the impact of FSP 157-3 was not material to the Company's
financial condition or results of operations.





The
Fair Value Option for Financial Assets and Financial Liabilities


In
February 2007, the FASB issued Statement of Financial Accounting Standards
No. 159, The Fair Value
Option for Financial Assets and Financial Liabilities (SFAS
No. 159), including an amendment of FASB Statement No. 115.  SFAS
No.159 permits fair value accounting to be irrevocably elected for certain
financial assets and liabilities on an individual contract basis at the time of
acquisition or at a remeasurement event date.  Upon adoption of SFAS
No. 159, fair value accounting may also be elected for existing financial assets
and liabilities.  For those instruments for which fair value
accounting is elected, changes in fair value will be recognized in earnings and
fees and costs associated with origination or acquisition will be recognized as
incurred rather than deferred.  The Company adopted SFAS No. 159 on
January 1, 2008, but did not elect the fair value option for any assets or
liabilities either existing at the time of adoption or acquired thereafter for
the year ended December 31, 2008.





Business
Combinations


In
December 2007, the FASB issued Statement of Financial Accounting Standards
No. 141 (revised 2007), Business Combinations(SFAS
No. 141R).  SFAS No. 141(R), among other things, establishes
principles and requirements for how the acquirer in a business combination
(i) recognizes and measures in its financial statements the identifiable
assets acquired, the liabilities assumed, and any noncontrolling interest in the
acquired business, (ii) recognizes and measures the goodwill acquired in
the business combination or a gain from a bargain purchase, and
(iii) determines what information to disclose to enable users of the
financial statements to evaluate the nature and financial effects of the
business combination.  The Company is required to adopt SFAS No.
141(R) for all business combinations for which the acquisition date is on or
after January 1, 2009.  Earlier adoption is
prohibited.  This Standard will change theCompany's accounting
treatment for business combinations on a prospective basis.





Noncontrolling
Interests in Consolidated Financial Statements


In
December 2007, the FASB issued Statement of Financial Accounting Standards
No. 160, Noncontrolling
Interests in Consolidated Financial Statements, an Amendment of ARB No.
51 (SFAS No. 160).  SFAS No. 160 establishes accounting and
reporting standards for noncontrolling interests in a subsidiary and for the
deconsolidation of a subsidiary.  Minority interests will be
recharacterized as noncontrolling interests and classified as a component of
equity.  It also establishes a single method of accounting for changes
in a parent's ownership interest in a subsidiary and requires expanded
disclosures.  This statement is effective for fiscal years beginning
on or after December 15, 2008, with early adoption prohibited. The Company
does not expect the adoption of this Statement will have a material impact on
its financial position, results of operations or cash flows.





Disclosures
about Derivative Instruments and Hedging Activities


In March
2008, the FASB issued Statement of Financial Accounting Standards No. 161,
Disclosures about Derivative
Instruments and Hedging Activities(SFAS No. 161).  This
statement requires enhanced disclosures to enable investors to better understand
the effects of derivative instruments and hedging activities on an entity's
financial position, financial performance, and cash flows, by requiring
disclosure of the fair value of derivative instruments and their gains and
losses in a tabular format.  It also provides more information about
an entity's liquidity by requiring disclosure of derivative features that are
related to credit risk.  It requires cross-referencing within
footnotes to enable financial statement users to locate important information
about derivative instruments.  SFAS No. 161 is effective for
fiscal years and interim periods beginning after November 15, 2008, with
early application encouraged.  Management does not expect the adoption
of this Statement will have a material impact on its financial position, results
of operations or cash flows.





The
Hierarchy of Generally Accepted Accounting Principles


In
May 2008, the FASB issued Statement of Financial Accounting Standards
No. 162, The Hierarchy of
Generally Accepted Accounting Principles (SFAS No. 162).  This
standard identifies a consistent framework, or hierarchy, for selecting
accounting principles to be used in preparing financial statements that are
presented in conformity with U.S. generally accepted accounting principles
(GAAP) for nongovernmental entities. It establishes that the GAAP hierarchy
should be directed to entities because it is the entity (not the auditor) that
is responsible for selecting accounting principles for financial statements that
are presented in conformity with GAAP.  SFAS No. 162 is effective
November 15, 2008 and there was no effect on the Company's consolidated
financial statements upon adoption.




-12-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE
3. INVESTMENT SECURITIES





The
amortized cost and estimated fair value of investment securities at December 31,
2008 and 2007 consisted of the following:





AVAILABLE-FOR-SALE
(AFS)




Table
      1: 2008 AFS Securities
                    
                    Amortized Cost
                    
                    
                    Gross Unrealized Gains
                    
                    
                    Gross Unrealized Losses
                    
                    
                    Estimated Fair Value(In
      thousands)Debt
      securities:U.S.Treasury
      securities
                    
                    $
                    9,937
                    
                    
                    $
                    240
                    
                    
                    $
                    -
                    
                    
                    $
                    10,177Obligations
      of states and political sub-divisions
                    
                    
                    3,154
                    
                    
                    
                    11
                    
                    
                    
                    (130
                    )
                    
                    
                    3,035Mortgage-backed
      securities
                    
                    
                    22,355
                    
                    
                    
                    318
                    
                    
                    
                    (2
                    )
                    
                    
                    22,671Corporate
      bonds
                    
                    
                    8,143
                    
                    
                    
                    4
                    
                    
                    
                    (4,338
                    )
                    
                    
                    3,809Total
                    
                    $
                    43,589
                    
                    
                    $
                    573
                    
                    
                    $
                    (4,470
                    )
                    
                    $
                    39,692


Net
unrealized losses on available-for-sale investment securities totaling
$2,297,000 were recorded, net of $1,600,000 in tax benefit, as accumulated other
comprehensive loss within shareholders' equity at December 31,
2008.  The Company realized losses of $7,789,000 on sales and calls of
securities in 2008.  The $7,789,000 included realized losses on an
other than temporary charge of $6,498,000 in the third quarter of 2008 related
to Fannie Mae and Freddie Mac preferred stock.  The Company
subsequently sold the preferred stock in the fourth quarter of 2008, realizing
an additional loss of $345,000.  The Company recorded another other
than temporary impairment charge of $2,425,000 on a single issue trust preferred
debenture in the fourth quarter of 2008 which has not been sold and realized
losses on other securities totaling $946,000 in the fourth quarter of
2008.  $6,011,000, net of tax benefit of $4,203,000, of unrealized
losses was reclassified from accumulated other comprehensive income to loss on
sale of securities and other than temporary impairment charge on the
consolidated statement of operations at the time the losses were realized or
determined to be other than temporarily impaired.




Table
      2: 2007 AFS Securities
                      
                      Amortized Cost
                      
                      
                      Gross Unrealized Gains
                      
                      
                      Gross Unrealized Losses
                      
                      
                      Estimated Fair Value(In
      thousands)Debt
      securities:U.S.
      Treasury securities
                      
                      $
                      17,424
                      
                      
                      $
                      58
                      
                      
                      $
                      -
                      
                      
                      $
                      17,482U.S.
      Government agencies
                      
                      
                      2,946
                      
                      
                      
                      4
                      
                      
                      
                      (15
                      )
                      
                      
                      2,935Obligations
      of states and political sub-divisions
                      
                      
                      3,059
                      
                      
                      
                      102
                      
                      
                      
                      
                      
                      
                      
                      3,161Mortgage-backed
      securities
                      
                      
                      8,754
                      
                      
                      
                      47
                      
                      
                      
                      (677
                      )
                      
                      
                      8,124Corporate
      bonds
                      
                      
                      9,755
                      
                      
                      
                      -
                      
                      
                      
                      (163
                      )
                      
                      
                      9,592Total
                      
                      $
                      41,938
                      
                      
                      $
                      211
                      
                      
                      $
                      (855
                      )
                      
                      $
                      41,294




Net
unrealized losses on available-for-sale investment securities totaling $644,000
were recorded, net of $258,000 in tax benefit, as accumulated other
comprehensive loss within shareholders' equity at December 31,
2007.  There were no proceeds or gross realized gains or losses from
the sale or call of available-for-sale investment securities for the year ended
December 31, 2007.




-13-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


HELD-TO-MATURITY
(HTM)




Table
      3: 2008 HTM Securities
                        
                        Amortized Cost
                        
                        
                        Gross Unrealized Gains
                        
                        
                        Gross Unrealized Losses
                        
                        
                        Estimated Fair Value(In
      thousands)Debt
      securities:Mortgage-backed
      securities
                        
                        $
                        46
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        46


Table
      4: 2007 HTM Securities
                          
                          Amortized Cost
                          
                          
                          Gross Unrealized Gains
                          
                          
                          Gross Unrealized Losses
                          
                          
                          Estimated Fair Value(In
      thousands)Debt
      securities:Mortgage-backed
      securities
                          
                          $
                          58
                          
                          
                          $
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          58




There
were no sales or transfers of held-to-maturity investment securities during the
years ended December 31, 2008, 2007 and 2006.




Investment
securities with unrealized losses at December 31, 2008 and 2007 are summarized
and classified according to the duration of the loss period as
follows:




Table
      5: 2008 Unrealized Security Losses on AFS
                  
                  Less than 12 Months
                  
                  
                  12 Months or More
                  
                  
                  Total(In
      thousands)
                  
                  Fair Value
                  
                  
                  Unrealized Losses
                  
                  
                  Fair Value
                  
                  
                  Unrealized Losses
                  
                  
                  Fair Value
                  
                  
                  Unrealized LossesDebt
      securities:Obligations
      of states and political sub-divisions
                  
                  $
                  1,325
                  
                  
                  $
                  (130
                  )
                  
                  $
                  -
                  
                  
                  
                  -
                  
                  
                  $
                  1,325
                  
                  
                  $
                  (130
                  )Mortgage-backed
      securities
                  
                  
                  10
                  
                  
                  
                  (1
                  )
                  
                  
                  433
                  
                  
                  
                  (1
                  )
                  
                  
                  443
                  
                  
                  
                  (2
                  )Corporate
      bonds
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2,726
                  
                  
                  
                  (4,338
                  )
                  
                  
                  3,226
                  
                  
                  
                  (4,338
                  )$
                  1,335
                  
                  
                  $
                  (131
                  )
                  
                  $
                  3,159
                  
                  
                  $
                  (4,339
                  )
                  
                  $
                  4,994
                  
                  
                  $
                  (4,470
                  )





Table
      6: 2007 Unrealized Security Losses on AFS
                    
                    Less than 12 Months
                    
                    
                    12 Months or More
                    
                    
                    Total(In
      thousands)
                    
                    Fair Value
                    
                    
                    Unrealized Losses
                    
                    
                    Fair Value
                    
                    
                    Unrealized Losses
                    
                    
                    Fair Value
                    
                    
                    Unrealized LossesDebt
      securities:U.S.
      Government Agencies
                    
                    $
                    993
                    
                    
                    $
                    (7
                    )
                    
                    $
                    884
                    
                    
                    $
                    (8
                    )
                    
                    $
                    1,877
                    
                    
                    $
                    (15
                    )Mortgage-backed
      securities
                    
                    
                    5,393
                    
                    
                    
                    (664
                    )
                    
                    
                    880
                    
                    
                    
                    (13
                    )
                    
                    
                    6,273
                    
                    
                    
                    (677
                    )Corporate
      bonds
                    
                    
                    2,080
                    
                    
                    
                    (79
                    )
                    
                    
                    930
                    
                    
                    
                    (84
                    )
                    
                    
                    3,010
                    
                    
                    
                    (163
                    )$
                    8,466
                    
                    
                    $
                    (750
                    )
                    
                    $
                    2,694
                    
                    
                    $
                    (105
                    )
                    
                    $
                    11,160
                    
                    
                    $
                    (855
                    )




-14-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


U.S.
Government Agency Securities


At
December 31, 2008, the Company did not own U.S. Government Agency
Securities.  At December 31, 2007, the Company held 5 U.S. Government
Agency Securities of which 1 was in a loss position for less than twelve months
and 3 were in a loss position and had been in a loss position for twelve months
or more.  Management believes the unrealized losses on the Company’s
investments in U.S. Government Agency Securities were caused by interest rate
increases and is not attributable to changes in credit
quality.  Because the decline in market value is attributable to
changes in interest rates and not credit quality, and because the Company has
the ability and intent to hold these investments until a recovery of fair value,
which may be maturity, the Company does not consider these investments to be
other-than-temporarily impaired at December 31, 2007.





Obligations
of states and political sub-divisions


At
December 31, 2008, the Company held 10 municipal debt securities, of which 3
were in an unrealized loss position.  Management believes the
unrealized losses on the Company’s investments in municipal bonds were caused by
market conditions and is not attributable to changes in credit
quality.  Because the decline in market value is attributable to
changes in market conditions and not credit quality, and because the Company has
the ability and intent to hold these investments until a recovery of fair value,
which may be maturity, the Company does not consider these investments to be
other-than-temporarily impaired at December 31, 2008.





Mortgage-Backed
Securities


At
December 31, 2008, the Company held 16 mortgage-backed investment securities of
which 4 were in a loss position for less than twelve months and none of the
securities were in a loss position for twelve months or
more.  Management believes that the unrealized losses on the Company's
investments in mortgage-backed investment securities were caused by market
conditions and is not attributable to changes in credit quality.  The
contractual cash flows of those investments are guaranteed by an agency of the
U.S. government.  Because the decline in market value is attributable
to changes in market conditions and not credit quality, and because the Company
has the ability and intent to hold those investments until a recovery of fair
value, which may be maturity, the Company does not consider those investments to
be other-than-temporarily impaired at December 31, 2008.





At
December 31, 2007, the Company held 9 mortgage-backed investment securities of
which 4 were in a loss position for less than twelve months and 1 was in a loss
position and had been in a loss position for twelve months or
more.  Management believes that the unrealized losses on the Company's
investments in mortgage-backed investment securities were caused by interest
rate increases and is not attributable to changes in credit
quality.  The contractual cash flows of those investments are
guaranteed by an agency of the U.S. government.  Because the decline
in market value is attributable to changes in interest rates and not credit
quality, and because the Company has the ability and intent to hold those
investments until a recovery of fair value, which may be maturity, the Company
does not consider those investments to be other-than-temporarily impaired at
December 31, 2007.





Corporate
Bonds


At
December 31, 2008, the Company held 9 corporate debt securities, of which 7 were
in an unrealized loss position.  Management believes the unrealized
losses on the Company’s investments in corporate bonds were caused by the demand
for these particular securities declining throughout the year but because the
Company has the ability and intent to hold these investments until a recovery of
fair value, which may be maturity, the Company does not consider these
investments to be other-than-temporarily impaired at December 31, 2008, with
exception of the investment discussed below.





At
December 31, 2008, the Company's investment securities included $2,500,000 of
trust preferred debentures issued by Temecula Valley Bancorp,
Inc.  Due to Temecula Valley Bancorp’s recent announcement of
deferring interest payments on this security and the subsequent decline in price
of the security, the Company recorded an other than temporary impairment write
down of $2,425,000 as of December 31, 2008.





At
December 31, 2007, the Company held 6 corporate debt securities, of which 4 were
in an unrealized loss position.  Management believes the unrealized
losses on the Company’s investments in corporate bonds were caused by interest
rate increases and is not attributable to changes in credit
quality.  Because the decline in market value is attributable to
changes in interest rates and not credit quality, and because the Company has
the ability and intent to hold these investments until a recovery of fair value,
which may be maturity, the Company does not consider these investments to be
other-than-temporarily impaired at December 31, 2007.




-15-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


The
amortized cost and estimated fair value of investment securities at December 31,
2008 by contractual maturity are shown below.  Expected maturities
will differ from contractual maturities because the issuers of the securities
may have the right to call or prepay obligations with or without call or
prepayment penalties.




Table
      7: Security Maturity Schedule
                      
                      Available-for-Sale
                      
                      
                      Held-to-Maturity(In
      thousands)
                      
                      Amortized
      Cost
                      
                      
                      Estimated
      Fair Value
                      
                      
                      Amortized
      Cost
                      
                      
                      Estimated
      Fair ValueWithin
      one year
                      
                      $
                      5,138
                      
                      
                      $
                      5,234
                      
                      
                      $
                      -
                      
                      
                      $
                      -After
      one year through five years
                      
                      
                      5,004
                      
                      
                      
                      5,151
                      
                      
                      
                      -
                      
                      
                      
                      -After
      five years through ten years
                      
                      
                      187
                      
                      
                      
                      187
                      
                      
                      
                      -
                      
                      
                      
                      -After
      ten years
                      
                      
                      10,905
                      
                      
                      
                      6,449
                      
                      
                      
                      -
                      
                      
                      
                      -21,234
                      
                      
                      
                      17,021
                      
                      
                      
                      -
                      
                      
                      
                      -Investment
      securities not due at a single maturity date:Mortgage-backed
      securities
                      
                      
                      22,355
                      
                      
                      
                      22,671
                      
                      
                      
                      46
                      
                      
                      
                      46$
                      43,589
                      
                      
                      $
                      39,692
                      
                      
                      $
                      46
                      
                      
                      $
                      46
  Investment
securities with amortized costs totaling $21,566,000 and $20,942,000 and
estimated market values totaling $21,044,000 and $20,984,000 were pledged to
secure treasury tax and loan accounts, public deposits and Federal Reserve Bank
advances at December 31, 2008 and 2007, respectively.  Certain
other investment securities are pledged to secure borrowings with the Federal
Home Loan Bank (see Note 7).




-16-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE
4. LOANS AND ALLOWANCE FOR LOAN LOSSES





Outstanding
loans are summarized below:





Table
      8: Loans Outstanding by Category
            
            December
      31,2008
            
            
            2007(In
      thousands)Commercial
            
            $
            81,284
            
            
            $
            83,012Agricultural
            
            
            13,153
            
            
            
            12,646Real
      estate - commercial mortgage
            
            
            135,013
            
            
            
            121,157Real
      estate - construction
            
            
            64,762
            
            
            
            80,168Installment
            
            
            13,609
            
            
            
            15,215Gross
      loans
            
            
            307,821
            
            
            
            312,198Deferred
      loan origination costs, net
            
            
            143
            
            
            
            208Allowance
      for loan losses
            
            
            (6,019
            )
            
            
            (3,948
            )Net
      loans
            
            $
            301,945
            
            
            $
            308,458





Changes
in the allowance for loan losses were as follows:





Table
      9: Changes in Allowance for Loan Losses
              
              Year
      Ended December 31,2008
              
              
              2007
              
              
              2006(In
      thousands)Balance,
      beginning of year
              
              $
              3,948
              
              
              $
              2,478
              
              
              $
              2,356Provision
      charged to operations
              
              
              7,001
              
              
              
              1,425
              
              
              
              360Losses
      charged to allowance
              
              
              (5,868
              )
              
              
              (161
              )
              
              
              (24
              )Recoveries
              
              
              938
              
              
              
              206
              
              
              
              1Reclassification
      of reserve for unfunded commitments
              
              
              -
              
              
              
              -
              
              
              
              (215
              )Balance,
      end of year
              
              $
              6,019
              
              
              $
              3,948
              
              
              $
              2,478





There
were eleven loans on nonaccrual status in the amount of $23,560,000 as of
December 31, 2008.  The Company recorded an allowance of $2,212,000
related to the loans on nonaccrual status.  There was one loan on
nonaccrual status in the amount of $432,000 as of December 31,
2007.  There were no loans considered impaired at December 31,
2006.  The Company did not recognize any interest income on impaired
or nonaccrual loans during 2008, 2007 and 2006.




The
average outstanding balance of impaired loans for the years ended
December 31, 2008, 2007 and 2006 was $9,591,000, $36,000 and $0,
respectively. The
interest foregone on nonaccrual loans was $736,000 at December 31,
2008.  The interest foregone on nonaccrual loans was not significant
at December 31, 2007 and 2006. Salaries
and employee benefits totaling $954,000, $1,006,000 and $227,000 have been
deferred as loan origination costs for the years ended December 31, 2008, 2007
and 2006, respectively.




-17-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE
5. PREMISES AND EQUIPMENT





Premises
and equipment consisted of the following:





Table
      10: Premises and Equipment
            
            December
      31,2008
            
            
            2007(In
      thousands)Land
            
            $
            4,955
            
            
            $
            4,956Buildings
      and improvements
            
            
            6,326
            
            
            
            5,987Furniture,
      fixtures and equipment
            
            
            5,159
            
            
            
            4,525Leasehold
      improvements
            
            
            1,807
            
            
            
            1,807Construction
      in progress
            
            
            4,172
            
            
            
            1,879Total
      gross premises and equipment
            
            
            22,419
            
            
            
            19,154Less
      accumulated depreciation and amortization
            
            
            (5,608
            )
            
            
            (4,885
            )Total
      premises and equipment
            
            $
            16,811
            
            
            $
            14,269





Depreciation
and amortization included in occupancy, furniture and equipment expense totaled
$826,000, $745,000, and $682,000 for the years ended December 31, 2008, 2007 and
2006, respectively.




NOTE
6. INTEREST-BEARING DEPOSITS





Interest-bearing
deposits consisted of the following:





Table
      11: Interest Bearing Deposits
            
            December
      31,2008
            
            
            2007(In
      thousands)Savings
            
            $
            8,920
            
            
            $
            5,154Money
      market
            
            
            55,294
            
            
            
            54,411NOW
      accounts
            
            
            18,390
            
            
            
            18,096Time
      deposits, $100,000 or
      more
            
            
            106,018
            
            
            
            127,731Time
      deposits under
      $100,000
            
            
            82,484
            
            
            
            69,358Total
      interest bearing
      deposits
            
            $
            271,106
            
            
            $
            274,750





Aggregate
annual maturities of time deposits are as follows:





Table
      12: Time Deposit Maturity Schedule
              
              Year
      Ending December 31, 2008(In
      thousands)2009
              
              $
              171,5542010
              
              
              7,7642011
              
              
              2,8692012
              
              
              5,3452013
              
              
              970Total
      time deposits
              
              $
              188,502




-18-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Interest
expense recognized on interest-bearing deposits consisted of the
following:





Table
      13: Deposit Interest Expense
            
            December
      31,2008
            
            
            2007
            
            
            2006(In
      thousands)Savings
            
            $
            42
            
            
            $
            46
            
            
            $
            56Money
      market
            
            
            1,386
            
            
            
            1,985
            
            
            
            2,122NOW
      accounts
            
            
            232
            
            
            
            246
            
            
            
            315Time
      deposits, $100,000 or
      more
            
            
            5,069
            
            
            
            6,657
            
            
            
            3,906Time
      deposits under
      $100,000
            
            
            3,696
            
            
            
            3,910
            
            
            
            1,703Total
      deposit interest
      expense
            
            $
            10,425
            
            
            $
            12,844
            
            
            $
            8,102




NOTE
7. OTHER BORROWINGS




The
Company has unsecured short-term borrowing arrangements totaling $26,000,000
with four of its correspondent banks.  There were no borrowings
outstanding under these arrangements at December 31, 2008 and 2007.


The
Company has a borrowing arrangement with the Federal Home Loan Bank of San
Francisco (FHLB) which allow the Company to borrow on either a short-term or
long-term basis up to approximately $93,112,000 and $77,886,000 as of December
31, 2008 and 2007 respectively based on specific percentages of the collateral
pledged.  For the years ended December 31, 2008 and 2007, various
mortgage loans secured a borrowing capacity of $85,571,000 and $71,741,000 and
investment securities secured borrowing capacity of $7,541,000 and $6,145,000,
respectively.  The Bank had an outstanding letter of credit with the
Federal Home Loan Bank in the amount of $26,282,000 at December 31,
2008.





Advances
from the FHLB at December 31, 2008 and 2007 consisted of the
following:


Table
14: FHLB Advances
 (Dollars
in thousands)
 December
      31,2008
              
              2007Balance
              
              
              Rate
              
              Maturity
      Date
              
              Balance
              
              
              Rate
              
              Maturity
      Date$
              10,000
              
              
              
              3.00
              %
              July
      2, 2009
              
              $
              35,000
              
              
              
              3.80
              %
              January
      2, 20081,000
              
              
              
              1.27
              %
              December
      15, 2009
              
              
              2,500
              
              
              
              4.41
              %
              December
      17, 201210,000
              
              
              
              3.22
              %
              January
      4, 2010
              
              
              2,500
              
              
              
              4.28
              %
              December
      18, 201215,000
              
              
              
              3.33
              %
              August
      23, 2010
              
              $
              40,0001,000
              
              
              
              2.20
              %
              December
      15, 20101,000
              
              
              
              2.61
              %
              December
      15, 20111,000
              
              
              
              2.82
              %
              December
      17, 20121,000
              
              
              
              2.97
              %
              December
      16, 2013$
              40,000


-19-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




NOTE
8. SUBORDINATED DEBENTURES




The
following is a summary of the subordinated debentures payable to the Company's
subsidiary grantor trusts at December 31, 2008 and 2007 (dollars in
thousands):




Table
      15: Subordinated Debentures Outstanding
                          
                          December 31,(In
      thousands)
                          
                          2008
                          
                          
                          2007Subordinated
      debentures due to Pacific State Statutory Trust II with interest payable
      quarterly based on 3-month LIBOR plus 2.79% (4.66% at December 31, 2008),
      and redeemable with no premium beginning March 17, 2009 and due March 17,
      2034.
                          
                          $
                          3,609
                          
                          
                          $
                          3,609Subordinated
      debentures due to Pacific State Statutory Trust III with interest payable
      quarterly based on 3-month LIBOR plus 1.45% (3.45% at December 31, 2008),
      and redeemable with no premium beginning September 16, 2012 and due
      September 16, 2037.
                          
                          
                          5,155
                          
                          
                          
                          5,155Total
      subordinated debentures
                          
                          $
                          8,764
                          
                          
                          $
                          8,764





The
Company has guaranteed, on a subordinated basis, distributions and other
payments due on the trust preferred securities issued by the subsidiary grantor
trusts.  Interest expense recognized by the Company for the years
ended December 31, 2008, 2007 and 2006 related to the subordinated debentures
was $464,000, $702,000 and $710,000, respectively.








NOTE
9. INCOME TAXES





The
(benefit from) provision for income taxes for the years ended December 31, 2008,
2007 and 2006 consisted of the following:





Table
      16: Income Tax (Benefit) Provision
                      
                      Federal
                      
                      
                      State
                      
                      
                      Total2008Current
                      
                      $
                      306
                      
                      
                      
                      (399
                      )
                      
                      $
                      (93
                      )Deferred
                      
                      
                      (3,839
                      )
                      
                      
                      (1,440
                      )
                      
                      
                      (5,279
                      )Benefit
      from income taxes
                      
                      $
                      (3,533
                      )
                      
                      $
                      (1,839
                      )
                      
                      $
                      (5,372
                      )2007Current
                      
                      $
                      2,776
                      
                      
                      $
                      873
                      
                      
                      $
                      3,649Deferred
                      
                      
                      (592
                      )
                      
                      
                      (163
                      )
                      
                      
                      (755
                      )Provision
      for income taxes
                      
                      $
                      2,184
                      
                      
                      $
                      710
                      
                      
                      $
                      2,8942006Current
                      
                      $
                      2,671
                      
                      
                      $
                      944
                      
                      
                      $
                      3,615Deferred
                      
                      
                      54
                      
                      
                      
                      (42
                      )
                      
                      
                      12Provision
      for income taxes
                      
                      $
                      2, 725
                      
                      
                      $
                      902
                      
                      
                      $
                      3,627




-20-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Deferred
tax assets (liabilities) consisted of the following:


Table
      17: Deferred Tax Assets and Liabilities
                                
                                December 31,2008
                                
                                
                                2007(In
      thousands)Deferred
      tax assets:Allowance
      for loan losses
                                
                                $
                                2,064
                                
                                
                                $
                                1,462Future
      benefit of state tax deduction
                                
                                
                                -
                                
                                
                                
                                280Deposit
      purchase premium
                                
                                
                                109
                                
                                
                                
                                102Deferred
      compensation
                                
                                
                                762
                                
                                
                                
                                517Off
      balance sheet reserve
                                
                                
                                92
                                
                                
                                
                                92Bank
      premises and equipment
                                
                                
                                -
                                
                                
                                
                                9Nonaccrual
      interest
                                
                                
                                341
                                
                                
                                
                                -Other
      than temporary impairment charges
                                
                                
                                1,455
                                
                                
                                
                                -Net
      operating loss
                                
                                
                                4,646
                                
                                
                                
                                -Unrealized
      losses on available-for-sale investment securities
                                
                                
                                1,602
                                
                                
                                
                                258Total
      deferred tax assets
                                
                                
                                11,071
                                
                                
                                
                                2,720Deferred
      tax liabilities:Bank
      premises and equipment
                                
                                $
                                (116
                                )
                                
                                $
                                -Mark
      to market adjustment
                                
                                
                                (1,604
                                )
                                
                                
                                (37
                                )Future
      expense of state tax refund
                                
                                
                                (645
                                )
                                
                                
                                -Goodwill
                                
                                
                                (130
                                )
                                
                                
                                (110
                                )FHLB
      dividends
                                
                                
                                (103
                                )
                                
                                
                                (66
                                )Prepaid
      expense
                                
                                
                                (188
                                )
                                
                                
                                (200
                                )Total
      deferred tax liabilities
                                
                                
                                (2,141
                                )
                                
                                
                                (413
                                )Net
      deferred tax assets
                                
                                $
                                8,930
                                
                                
                                $
                                2,307





The
Company and its subsidiaries file income tax returns in the United States and
California jurisdictions.  With few exceptions, the Company is no
longer subject to Federal income tax examinations for years before 2004 and
State income tax examinations by tax authorities for years before
2003.


The
Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income
Taxes, on January 1, 2007.  No adjustments were identified for
unrecognized tax benefits which would require an adjustment to the January 1,
2007 beginning tax reserve.  The Company had no tax reserve for
uncertain positions at year-end.  The Company does not anticipate
providing a reserve for uncertain positions in the next 12 months.  In
accordance with FIN 48, the Company has elected to record interest accrued and
penalties related to unrecognized tax benefits in tax expense.  During
the years ended December 31, 2008 and 2007 the Company did not have an accrual
for interest and/or penalties associated with uncertain tax
positions.


The
provision for income taxes differs from amounts computed by applying the
statutory Federal income tax rates to operating income before income
taxes.  The significant items comprising these differences for the
years ended December 31, 2008, 2007 and 2006 consisted of the
following:




Table
      18: Income Tax Rate Reconciliation
                        
                        2008
                        
                        
                        2007
                        
                        
                        2006Federal
      income tax, at statutory rate
                        
                        
                        (34.0
                        )%
                        
                        
                        34.0
                        %
                        
                        
                        34.0
                        %State
      franchise tax, net of Federal tax effect
                        
                        
                        (9.5
                        )%
                        
                        
                        6.3
                        %
                        
                        
                        6.5
                        %Tax
      exempt investment security income, net
                        
                        
                        (0.3
                        )%
                        
                        
                        (0.4
                        )%
                        
                        
                        (0.7
                        )%Company
      owned life insurance, net
                        
                        
                        (1.0
                        )%
                        
                        
                        (1.1
                        )%
                        
                        
                        (0.8
                        )%Gain
      on Company owned life insurance
                        
                        
                        (8.3
                        )%
                        
                        
                        -
                        %
                        
                        
                        -
                        %Other
                        
                        
                        2.2
                        %
                        
                        
                        0.1
                        %
                        
                        
                        0.6
                        %Effective
      tax rate
                        
                        
                        (50.9
                        )%
                        
                        
                        38.9
                        %
                        
                        
                        39.6
                        %


-21-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE
10. COMMITMENTS AND CONTINGENCIES








LEASES


The
Company leases branch offices and certain equipment under non-cancelable
operating leases.  The leases expire on various dates through 2016 and
have various renewal options ranging from five to ten years.





Future
minimum lease payments are as follows (in thousands):


Table 19: Future Lease
      Commitments
                    
                    Year Ending December 31,
    2008(In
      thousands)2009
                    
                    $
                    2742010
                    
                    
                    1992011
                    
                    
                    2052012
                    
                    
                    2122013
                    
                    
                    218Thereafter
                    
                    
                    593Total
                    
                    $
                    1,701


Rental
expense included in occupancy, furniture and equipment expense totaled $496,000,
$383,000 and $319,000 for the years ended December 31, 2008, 2007 and 2006,
respectively.





FEDERAL
RESERVE REQUIREMENTS


Banks are
required to maintain a combination of reserves with the Federal Reserve Bank and
vault cash equal to a percentage of their reservable deposits.  The
reserve balances held with the Federal Reserve Bank or in the form of vault cash
totaled $4,451,000 and $3,951,000 as of December 31, 2008 and 2007,
respectively.





CORRESPONDENT
BANKING AGREEMENTS


The
Company maintains funds on deposit with other federally insured financial
institutions under correspondent banking agreements.  Some of those
insured financial institutions have elected to participate in the FDIC sponsored
Transaction Account Guarantee Program.  Under that program, through
December 31, 2009, all noninterest-bearing transaction accounts are fully
guaranteed by the FDIC for the entire amount in the account.  Coverage
under the Transaction Account Guarantee Program is in addition to and separate
from the coverage available under the FDIC's general deposit insurance
rules.  Uninsured deposits held at institutions not participating in
this program totaled $65,000 at December 31, 2008.This program was not in effect
in 2007 and uninsured deposits totaled $9,484,000 at December 31,
2007.





FINANCIAL
INSTRUMENTS WITH OFF-BALANCE-SHEET RISK


The
Company is a party to financial instruments with off-balance-sheet risk in the
normal course of business in order to meet the financing needs of its customers
and to reduce its own exposure to fluctuations in interest
rates.  These financial instruments consist of commitments to extend
credit and standby letters of credit.  These instruments involve, to
varying degrees, elements of credit and interest rate risk in excess of the
amount recognized on the balance sheet.


The
Company's exposure to credit loss in the event of nonperformance by the other
party for commitments to extend credit and standby letters of credit is
represented by the contractual amount of those instruments.  The
Company uses the same credit policies in making commitments and standby letters
of credit as it does for loans included on the balance sheet.


-22-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


The
following financial instruments represent off-balance-sheet credit
risk:





Table
20: Commitments


December
      31,2008
            
            
            2007(In
      thousands)Commitments
      to extend credit
            
            $
            55,522
            
            
            $
            121,255Standby
      letters of credit
            
            $
            1,557
            
            
            $
            3,491





Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract.  Commitments
generally have fixed expiration dates or other termination clauses and may
require payment of a fee.  Since some of the commitments are expected
to expire without being drawn upon, the total commitment amounts do not
necessarily represent future cash requirements.  The Company evaluates
each customer's creditworthiness on a case-by-case basis.  The amount
of collateral obtained, if deemed necessary by the Company upon extension of
credit, is based on management's credit evaluation of the
borrower.  Collateral held varies, but may include accounts
receivable, inventory, equipment, income-producing commercial properties and
residential real estate.


Standby
letters of credit are conditional commitments issued by the Company to guarantee
the performance or financial obligation of a customer to a third
party.  The credit risk involved in issuing letters of credit is
essentially the same as that involved in extending loans to
customers.  The fair value of the liability related to these standby
letters of credit, which represents the fees received for issuing the
guarantees, was not significant at December 31, 2008 and 2007.  The
Company recognizes these fees as revenue over the term of the commitment or when
the commitment is used.


At
December 31, 2008, commercial loan commitments represent approximately 51% of
total commitments and are generally secured by various assets of the
borrower.  Real estate loan commitments represent approximately 34% of
total commitments and are generally secured by property with a loan-to-value
ratio not to exceed 75% to 80%.  With the decline in the real estate
market, the Company has experienced increasing loan-to-value
ratios.  In cases where loan-to-value ratios have increased to a level
above underwriting standards, the Company has reduced available lines to meet
those standards.  In addition, the Company has reduced open
construction commitments from $46,358,000 at December 31, 2007 to $11,778,000 at
December 31, 2008.  Consumer loan commitments represent the remaining
15% of total commitments and are generally unsecured.  In addition,
the majority of the Company's commitments have either variable interest rates or
short term fixed rates.





CONCENTRATIONS
OF CREDIT RISK


The
Company's customers are primarily located in San Joaquin, Stanislaus, Calaveras,
Alameda, and Tuolumne Counties.  At December 31, 2008, approximately
26% of the Company's loans are for general commercial uses, including
professional, retail and small business, and 4% are for agricultural
uses.  Additionally, 21% of the Company's loans are for the
construction of residential and commercial real estate and 44% are loans which
are collateralized by mortgages on residential and commercial real
estate.  Generally, real estate loans are secured by real property
while commercial and other loans are secured by funds on deposit and business or
personal assets.  The remaining 5% of the Company's loans are consumer
installment loans.  Repayment is generally expected from the proceeds
of property sales and permanent financing for real estate construction loans and
borrower cash flows for other loans.





CONTINGENCIES


The
Company is subject to legal proceedings and claims which arise in the ordinary
course of business.  In the opinion of management, the amount of
ultimate liability with respect to such actions will not materially affect the
consolidated financial position or consolidated results of operations of the
Company.





NOTE
11. SHAREHOLDERS' EQUITY




DIVIDENDS


The
Company's ability to pay cash dividends is dependent on dividends paid to it by
the Bank and limited by California corporation law.  Under California
law, the holders of common stock of the Company are entitled to receive
dividends when and as declared by the Board of Directors, out of funds legally
available, subject to certain restrictions.  The California general
corporation law prohibits the Company from paying dividends on its common stock
unless: (i) its retained earnings, immediately prior to the dividend payment,
equals or exceeds the amount of the dividend or (ii) immediately after giving
effect to the dividend, the sum of the Company's assets (exclusive of goodwill
and deferred charges) would be at least equal to 125% of its liabilities (not
including deferred taxes, deferred income and other deferred liabilities) and
the current assets of the Company would be at least equal to its current
liabilities, or, if the average of its earnings before taxes on income and
before interest expense for the two preceding fiscal years was less than the
average of its interest expense for the two preceding fiscal years, at least
equal to 125% of its current liabilities.  In addition, the Company's
ability to pay dividends is subject to certain covenants contained in the
indentures related to the trust preferred securities issued by the
Trusts.


Upon
declaration by the Board of Directors of the Company, all shareholders of record
will be entitled to receive dividends.  A significant source of cash
for the Company is dividends from the Bank.  The California Financial
Code restricts the total dividend payment of any bank in any calendar year to
the lesser of (1) the bank's retained earnings or (2) the bank's net income for
its last three fiscal years, less distributions made to shareholders during the
same three-year period.  As a member of the Federal Reserve System,
the Bank is also subject to similar restrictions imposed by Federal
law.  At December 31, 2008, Bank retained earnings of $4,653,000 were
free of such restrictions and available for dividend payments to
Bancorp.


-23-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 (CONTINUED)


EARNINGS
(LOSS) PER SHARE


A
reconciliation of the numerators and denominators of the basic and diluted
earnings (loss) per share computations is as follows:





Table
      21: (Loss) Earnings Per Share Calculation
            
            For
      The Year Ended December 31,(Amounts
      in thousands, except per share data)
            
            2008
            
            
            2007
            
            
            2006Basic
      (Loss) Earnings Per Share Computations:Net
      (loss) income
            
            $
            (5,190
            )
            
            $
            4,549
            
            
            $
            5,543Average
      common shares outstanding
            
            
            3,710
            
            
            
            3,687
            
            
            
            3,537Basic
      (loss) earnings per share
            
            $
            (1.40
            )
            
            $
            1.23
            
            
            $
            1.57Diluted
      Earnings (Loss) Per Share Computations:Net
      (loss) income
            
            $
            (5,190
            )
            
            $
            4,549
            
            
            $
            5,543Average
      common shares outstanding
            
            
            3,710
            
            
            
            3,687
            
            
            
            3,537Effect
      of stock options
            
            
            -
            
            
            
            317
            
            
            
            386Total
      Weighted Average Shares and Common Stock Equivalents
            
            
            3,710
            
            
            
            4,004
            
            
            
            3,923Diluted
      (loss) earnings per share
            
            $
            (1.40
            )
            
            $
            1.14
            
            
            $
            1.41




In 2008,
there were no adjustments for the effect of stock options since any adjustment
would be anti-dilutive to the Company’s net loss.  30,000 stock
options were not included in the 2007 calculation as they were
anti-dilutive.  All of the stock options outstanding were included in
the computation of diluted earnings per share for the year ended December 31,
2006 as none of the stock options were anti-dilutive.





STOCK
OPTION PLAN


The
Company currently has one shareholder approved stock option plan, the Pacific
State Bancorp 1997 Stock Option Plan. At December 31, 2008, the plan has 663,769
shares remaining as reserved for issuance for options already granted. Under the
1997 Plan 26,954 shares of common stock remain reserved for future issuance to
directors through nonstatutory agreements.  The plan requires that the
price may not be less than the fair market value of the Company’s common stock
at the date of grant and that the stock must be paid in full at the time the
option is exercised.  The Plan does not provided for the settlement of
awards in cash and new shares are issued upon the exercise of the options. There
was one grant of 30,000 stock options made in 2007 and no options were granted
in 2008 or 2006. The options under the plan expire on dates determined by the
Board of Directors, but not longer than ten years from the date of grant. The
vesting period is generally over five years.





STOCK
OPTION COMPENSATION EXPENSE


The
compensation cost that has been charged against income for stock options was
$270,000, $309,000 and $229,000 for the years ended December 31, 2008, 2007 and
2006, respectively.  The total income tax benefit recognized in
shareholders equity for stock options exercised was $4,000, $223,000, and
$736,000 for the years ended December 31, 2008, 2007 and 2006,
respectively.


At
December 31, 2008, the total compensation cost related to nonvested stock option
awards granted to employees under the Company’s stock option plans but not yet
recognized was $200,000.  Stock option compensation expense is
recognized on a straight-line basis over the vesting period of the
option.  This cost is expected to be recognized over a weighted
average remaining period of 1.9 years and will be adjusted for subsequent
changes in estimated forfeitures.  The total fair value of options
vested during the years ended December 31, 2008, 2007 and 2006 was $270,000,
$309,000 and $229,000, respectively.


-24-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 (CONTINUED)


A summary
of the activity within the plan follows:


2008
                
                2007Table
      22: Stock Option Activity
                Shares
                
                Weighted
      Average Exercise Price
                
                Shares
                Weighted
      Average Exercise PriceOptions
      outstanding,beginning
      of year
                656,769
                
                $
                7.69
                
                668,499
                $
                7.04Options
      granted
                -
                
                $
                -
                
                30,000
                $
                19.70Options
      exercised
                (10,900)
                )
                $
                4.98
                
                (41,730)
                )$
                5.62Options
      cancelled
                -
                
                $
                -
                
                -
                $
                -Options
      outstanding,end
      of year
                645,869
                
                $
                7.73
                
                656,769
                $
                7.69Options
      exercisable,end
      of year
                621,869
                
                $
                7.27
                
                515,622
                $
                7.01




The
aggregate intrinsic value is calculated as the difference between the exercise
price of the underlying awards and the quoted price of the Company’s common
stock for options that were in-the-money at December 31, 2008.  The
intrinsic value of options outstanding and exercisable as of December 31, 2008
relating to the above stock option plans was $1,000. The intrinsic value of
options vested or expected to vest as of December 31, 2008 relating to the above
stock option plans was $1,000.  The weighted average remaining
contractual term for options outstanding and exercisable was 4.85 years. During
the years ended December 31, 2008, 2007 and 2006, the aggregate intrinsic value
of options exercised was $52,000, $569,000, and $1,011,000,
respectively.


The cash
received from options exercised for the years ended December 31, 2008, 2007 and
2006 was $75,000, $235,000 and $880,000, respectively.  The actual tax
benefit realized for the tax deductions from options exercised was $4,000,
$223,000 and $736,000 for the years ended December 31, 2008, 2007 and 2006,
respectively.


-25-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


REGULATORY
CAPITAL


The
Company and the Bank are subject to certain regulatory capital requirements
administered by the Board of Governors of the Federal Reserve System (FRB) and
the Federal Deposit Insurance Corporation (FDIC).  Failure to meet
these minimum capital requirements can initiate certain mandatory, and possibly
additional discretionary, actions by regulators that, if undertaken, could have
a direct material effect on the Company’s consolidated financial
statements.  Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, the Bank must meet specific capital
guidelines that involve quantitative measures of its assets, liabilities and
certain off-balance-sheet items as calculated under regulatory accounting
practices.  The Company’s and the Bank’s capital amounts and
classification are also subject to qualitative judgments by the regulators about
components, risk weightings and other factors.


Under
capital adequacy guidelines and the regulatory framework for prompt corrective
action, the Bank must meet specific capital guidelines that involve quantitative
measures of its assets, liabilities and certain off-balance-sheet items as
calculated under regulatory accounting practices.  The Company’s and
the Bank’s capital amounts and classification are also subject to qualitative
judgments by the regulators about components, risk weightings and other
factors.


Quantitative
measures established by regulation to ensure capital adequacy require the
Company and the Bank to maintain minimum amounts and ratios of total and
Tier 1 capital to risk-weighted assets and of Tier 1 capital to average
assets as set forth on the following table.  Each of these components
is defined in the regulations.  Management believes that the Company
and the Bank met all their capital adequacy requirements as of December 31,
2008 and 2007.


In
addition, the most recent notification from the FDIC categorized the Bank as
well capitalized under the regulatory framework for prompt correction
action.  To be considered well capitalized, the Bank must maintain
minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set
forth below.  There are no conditions or events since December 31,
2008 that management believes have changed the Bank's category.




Table 23: Regulatory
Capital
                        
                        Actual
                        
                        
                        Adequacy Purposes
                        
                        
                        Action Provisions(Dollars
      in thousands)
                        
                        Amount
                        
                        
                        Ratio
                        
                        
                        Minimum Amount
                        
                        
                        Minimum Ratio
                        
                        
                        Minimum Amount
                        
                        
                        Minimum RatioDecember 31, 2008Pacific
      State Bancorp:Total
      capital (to risk-weighted assets)
                        
                        $
                        41,903
                        
                        
                        
                        11.5
                        %
                        
                        $
                        29,143
                        
                        
                        
                        8.0
                        %
                        
                        
                        N/A
                        
                        
                        
                        N/ATier
      1 capital (to risk weighted assets)
                        
                        $
                        37,336
                        
                        
                        
                        10.3
                        %
                        
                        $
                        14,562
                        
                        
                        
                        4.0
                        %
                        
                        
                        N/A
                        
                        
                        
                        N/ATier
      1 capital (to average assets)
                        
                        $
                        37,336
                        
                        
                        
                        8.6
                        %
                        
                        $
                        17,310
                        
                        
                        
                        4.0
                        %
                        
                        
                        N/A
                        
                        
                        
                        N/APacific
      State Bank:Total
      capital (to risk-weighted assets)
                        
                        $
                        41,275
                        
                        
                        
                        11.3
                        %
                        
                        $
                        29,107
                        
                        
                        
                        8.0
                        %
                        
                        $
                        36,384
                        
                        
                        
                        10.0
                        %Tier
      1 capital (to risk-weighted assets)
                        
                        $
                        36,708
                        
                        
                        
                        10.1
                        %
                        
                        $
                        14,554
                        
                        
                        
                        4.0
                        %
                        
                        $
                        21,830
                        
                        
                        
                        6.0
                        %Tier
      1 capital (to average assets)
                        
                        $
                        36,708
                        
                        
                        
                        8.7
                        %
                        
                        $
                        16,819
                        
                        
                        
                        4.0
                        %
                        
                        $
                        21,023
                        
                        
                        
                        5.0
                        %December 31, 2007Pacific
      State Bancorp:Total
      capital (to risk-weighted assets)
                        
                        $
                        46,285
                        
                        
                        
                        12.6
                        %
                        
                        $
                        29,433
                        
                        
                        
                        8.0
                        %
                        
                        
                        N/A
                        
                        
                        
                        N/ATier
      1 capital (to risk weighted assets)
                        
                        $
                        42,018
                        
                        
                        
                        11.4
                        %
                        
                        $
                        14,717
                        
                        
                        
                        4.0
                        %
                        
                        
                        N/A
                        
                        
                        
                        N/ATier
      1 capital (to average assets)
                        
                        $
                        42,018
                        
                        
                        
                        10.2
                        %
                        
                        $
                        16,524
                        
                        
                        
                        4.0
                        %
                        
                        
                        N/A
                        
                        
                        
                        N/APacific
      State Bank:Total
      capital (to risk-weighted assets)
                        
                        $
                        44,368
                        
                        
                        
                        12.1
                        %
                        
                        $
                        29,256
                        
                        
                        
                        8.0
                        %
                        
                        $
                        36,570
                        
                        
                        
                        10.0
                        %Tier
      1 capital (to risk-weighted assets)
                        
                        $
                        40,198
                        
                        
                        
                        11.0
                        %
                        
                        $
                        14,628
                        
                        
                        
                        4.0
                        %
                        
                        $
                        21,942
                        
                        
                        
                        6.0
                        %Tier
      1 capital (to average assets)
                        
                        $
                        40,198
                        
                        
                        
                        9.8
                        %
                        
                        $
                        16,428
                        
                        
                        
                        4.0
                        %
                        
                        $
                        20,535
                        
                        
                        
                        5.0
                        %
  -26-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 (CONTINUED)
  NOTE
12. OTHER EXPENSES




Other
expenses consisted of the following:





Table
      24: Other Expenses
            
            Year
      Ended December 31,(In
      thousands)2008
            
            
            2007
            
            
            2006Professional
      fees
            
            $
            1,253
            
            
            $
            294
            
            
            $
            349Data
      processing
            
            
            588
            
            
            
            328
            
            
            
            286Advertising
      and promotion
            
            
            408
            
            
            
            564
            
            
            
            365Directors
      fees
            
            
            321
            
            
            
            290
            
            
            
            274Postage,
      stationery and supplies
            
            
            272
            
            
            
            212
            
            
            
            184Telephone
            
            
            265
            
            
            
            251
            
            
            
            210Appraisal
      fees
            
            
            262
            
            
            
            266
            
            
            
            337Other
      real estate owned
            
            
            94
            
            
            
            -
            
            
            
            -Other
      operating expenses
            
            
            2,036
            
            
            
            1,568
            
            
            
            1,224Total
      other expense
            
            $
            5,499
            
            
            $
            3,773
            
            
            $
            3,229





NOTE
13. LOANS TO RELATED PARTIES




During
the normal course of business, the Company enters into loans with related
parties, including executive officers and directors.  These loans are
made with substantially the same terms, including rates and collateral, as loans
to unrelated parties.  The following is a summary of the aggregate
activity involving related party borrowers (in thousands):





Table
25: Related Party Loans


Balance,
      January 1, 2008
                  
                  $
                  4,672,000Disbursements
                  
                  
                  3,531,000Amounts
      repaid
                  
                  
                  (5,930,000
                  )Balance,
      December 31, 2008
                  
                  $
                  2,273,000Undisbursed
      commitments to related parties, December 31, 2008
                  
                  $
                  2,604,000
  NOTE
14. EMPLOYEE BENEFIT PLANS




The
401(k) Savings Plan established by the Bank in 1990 was converted into a Company
plan in 2002.  Under the provisions of the plan, the Company matches
one-half of the employees' contributions up to a maximum of three percent of an
employee's annual salary.  All employees who are at least 21 years of
age and have completed one year of service are eligible under the
plan.  The Company's contributions vest at a rate of 20% after one
year of service and an additional 20% for each year
thereafter.  Contributions to the plan totaled $66,000, $18,000 and
$21,000 for the years ended December 31, 2008, 2007 and 2006,
respectively.





SALARY
CONTINUATION AND RETIREMENT PROGRAMS


The Board
of Directors approved salary continuation and retirement programs for six key
employees in 2003, one in 2007 and an additional 2 in 2008.  Two of
these agreements have been terminated due to the death of one employee and the
resignation of another.  The accrued balances related to the
terminated contracts were reversed from expense in 2008.  Under these
plans, the employees will receive monthly payments for twenty years after
retirement.  These benefits are substantially equivalent to those
available under split-dollar life insurance policies purchased by the Company on
the lives of the employees.  In addition, the estimated present value
of these future benefits is accrued over the period from the effective dates of
the plans until the participants' expected retirement dates based on a 7%
discount rate.  The expense recognized under these plans for the years
ended December 31, 2008 and 2007 totaled $90,000 and $231,000,
respectively.  Accrued compensation payable under the plans totaled
$1,106,000 and $1,016,000 at December 31, 2008 and 2007,
respectively.


In
connection with these plans, the Company purchased single premium life insurance
policies with cash surrender values totaling $6,751,000 at December 31,
2008.  During 2008, one employee covered by the Company owned life
insurance policy passed away.  As a result, the Company received
$1,591,000 in cash surrender value and $2,574,000 in death benefit in
cash.  Income earned on these policies, net of expenses, totaled
$318,000, $246,000 and $208,000 for the years ended December 31, 2008, 2007
and 2006, respectively.  Income earned on these policies is not
subject to federal or state income tax under certain circumstances.


-27-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE
15. COMPREHENSIVE (LOSS) INCOME




Comprehensive
(loss) income is a more inclusive financial reporting methodology that includes
disclosure of other comprehensive (loss) income that historically has not been
recognized in the calculation of net income.  The Company's only
source of other comprehensive income (loss) is unrealized gains and losses on
the Company's available-for-sale investment securities.  Total
comprehensive income and the components of accumulated other comprehensive
income (loss) are presented in the consolidated statement of changes in
shareholders' equity.





At
December 31, 2008, 2007 and 2006, the Company held securities classified as
available-for-sale which had changes in net unrealized gains or losses as
follows:


Table
      26: Other Comprehensive Income(In
      thousands)
                  
                  2008
                  
                  
                  2007
                  
                  
                  2006Unrealized
      holding (losses) gains
                  
                  $
                  (3,897
                  )
                  
                  $
                  (565
                  )
                  
                  $
                  78Tax
      benefit (expense) on unrealized holding gains
                  
                  
                  1,600
                  
                  
                  
                  258
                  
                  
                  
                  (30
                  )Total
      other comprehensive (loss) income
                  
                  $
                  (2,297
                  )
                  
                  $
                  (307
                  )
                  
                  $
                  48


-28-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 (CONTINUED)


NOTE
16. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS


The
estimated carrying and fair values of the Company's financial instruments are as
follows:





Table 27: Fair Value of Financial
Instruments


December
      31, 2008
              
              
              December
      31, 2007Carrying
              
              
              Fair
              
              
              Carrying
              
              
              Fair(In
      thousands)
              
              Amount
              
              
              Value
              
              
              Amount
              
              
              ValueFinancial
      assets:Cash
      and due from banks
              
              $
              16,700
              
              
              $
              16,700
              
              
              $
              13,794
              
              
              $
              13,794Federal
      funds sold
              
              
              21,811
              
              
              
              21,811
              
              
              
              31,880
              
              
              
              31,880Interest
      bearing deposits in other banks
              
              
              -
              
              
              
              -
              
              
              
              3,000
              
              
              
              3,000Investment
      securities
              
              
              39,738
              
              
              
              39,738
              
              
              
              41,352
              
              
              
              41,352Loans,
      net
              
              
              301,945
              
              
              
              305,257
              
              
              
              308,458
              
              
              
              306,198Company
      owned life insurance
              
              
              6,751
              
              
              
              6,751
              
              
              
              8,025
              
              
              
              8,025Accrued
      interest receivable
              
              
              1,394
              
              
              
              1,394
              
              
              
              8,002
              
              
              
              8,002Other
      investments
              
              
              2,447
              
              
              
              2,447
              
              
              
              2,294
              
              
              
              2,294Financial
      liabilities:Deposits
              
              
              340,980
              
              
              
              343,084
              
              
              
              341,821
              
              
              
              343,373Other
      borrowings
              
              
              40,000
              
              
              
              40,019
              
              
              
              40,000
              
              
              
              40,019Subordinated
      debentures
              
              
              8,764
              
              
              
              2,918
              
              
              
              8,764
              
              
              
              8,630Accrued
      interest payable
              
              $
              2,102
              
              
              $
              2,102
              
              
              $
              2,891
              
              
              $
              2,891


These
estimates do not reflect any premium or discount that could result from offering
the Company's entire holdings of a particular financial instrument for sale at
one time, nor do they attempt to estimate the value of anticipated future
business related to the instruments.  In addition, the tax
ramifications related to the realization of unrealized gains and losses can have
a significant effect on fair value estimates and have not been considered in any
of these estimates.


The
following methods and assumptions were used to estimate the fair value of
financial instruments.  For cash and cash equivalents, variable-rate
loans and leases, accrued interest receivable and payable, FHLB stock, demand
deposits and short-term borrowings, the carrying amount is estimated to be fair
value.  For investment securities, fair values are based on quoted
market prices, quoted market prices for similar securities and indications of
value provided by brokers.  The fair values for fixed-rate loans are
estimated using discounted cash flow analyses, using interest rates currently
being offered at each reporting date for loans with similar terms to borrowers
of comparable creditworthiness. Fair values for fixed-rate certificates of
deposit are estimated using discounted cash flow analyses using interest rates
offered at each reporting date by the Company for certificates with similar
remaining maturities.  The fair value of subordinated debentures was
determined based on the current market for like-kind instruments of a similar
maturity and structure.  The fair values of commitments are estimated
using the fees currently charged to enter into similar agreements and are not
significant and, therefore, not included in the above table.





FAIR
VALUE MEASUREMENTS UNDER SFAS 157


On
January 1, 2008, the Company adopted Financial Accounting Standards Board (FASB)
Statement No. 157 (SFAS 157),Fair Value
Measurements.  SFAS No. 157 defines fair value,
establishes a framework for measuring fair value under generally accepted
accounting principles, and expands disclosures about fair value
measurement.  Upon adoption of SFAS No. 157, there was no
cumulative effect adjustment to beginning retained earnings and no impact on the
consolidated financial statements.


-29-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Fair
Value Hierarchy





In
accordance with SFAS No. 157, the Company groups its assets and liabilities
measured at fair value in three levels, based on the markets in which the assets
and liabilities are traded and the reliability of the assumptions used to
determine fair value.  Valuations within these levels are based
upon:





Level 1 –
Quoted market prices for identical instruments traded in active exchange
markets.





Level 2 –
Quoted prices for similar instruments in active markets, quoted prices for
identical or similar instruments in markets that are not active, and model-based
valuation techniques for which all significant assumptions are observable or can
be corroborated by observable market data.





Level 3 –
Model-based techniques that use at least one significant assumption not
observable in the market.  These unobservable assumptions reflect the
Company's estimates of assumptions that market participants would use on pricing
the asset or liability.  Valuation techniques include management
judgment and estimation which may be significant.








Assets
Recorded at Fair Value





The
following tables present information about the Company's assets and liabilities
measured at fair value on a recurring and nonrecurring basis as of
December 31, 2008:





Recurring
Basis:





The
Company is required or permitted to record the following assets at fair value on
a recurring basis under other accounting pronouncements.





Description
            
            Fair Value
            
            
            Level 1
            
            
            Level 2
            
            
            Level 3Available-for-sale
      investment securities
            
            $
            39,738
            
            
            $
            39,738
            
            
            $
            -
            
            
            $
            -





Fair
values for available-for-sale investment securities, which include debt
securities of U.S. Government treasuries, U.S. Governmental agencies,
obligations of states and political subdivisions and corporate bonds are based
on quoted market prices for similar securities.





Non-recurring
Basis:





The
Company may be required, from time to time, to measure certain assets at fair
value on a non-recurring basis.  These include assets that are
measured at the lower of cost or market value that were recognized at fair value
which was below cost at the reporting date.





Description
            
            Fair Value
            
            
            Level 1
            
            
            Level 2
            
            
            Level 3Impaired
      loans
            
            $
            10,111
            
            
            $
            -
            
            
            $
            -
            
            
            $
            10,111





The fair
value of impaired loans is based on the fair value of the collateral for all
collateral dependent loans and for other impaired loans is estimated using a
discounted cash flow model.  Impaired loans were determined to be
collateral dependent and categorized as Level 3 due to ongoing real estate
market conditions resulting in inactive market data, which in turn required the
use of unobservable inputs and assumptions in fair value
measurements.





-30-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 (CONTINUED)


NOTE
17. PARENT ONLY CONDENSED FINANCIAL STATEMENTS




CONDENSED
BALANCE SHEET


December
31, 2008 and 2007


(In
thousands)





Table
      28: Condensed Balance Sheet
            
            2008
            
            
            2007ASSETSCash
      and cash
      equivalents
            
            $
            470
            
            
            $
            -Investment
      in bank
      subsidiary
            
            
            35,157
            
            
            
            40,621Investment
      in Pacific State Statutory Trust II and
      III
            
            
            264
            
            
            
            264Other
      assets
            
            
            204
            
            
            
            1,976Total
      assets
            
            $
            36,095
            
            
            $
            42,861LIABILITIES
      ANDSHAREHOLDERS'
      EQUITYLiabilities:Subordinated
      debentures
            
            $
            8,764
            
            
            $
            8,764Other
      liabilities
            
            
            47
            
            
            
            61Total
      liabilities
            
            
            8,811
            
            
            
            8,825Shareholders'
      equity:Common
      stock
            
            
            10,767
            
            
            
            10,418Retained
      earnings
            
            
            18,814
            
            
            
            24,004Accumulated
      other comprehensive loss, net of taxes
            
            
            (2,297
            )
            
            
            (386
            )Total
      shareholders'
      equity
            
            
            27,284
            
            
            
            34,036Total
      liabilities and shareholders'
      equity
            
            $
            36,095
            
            
            $
            42,861




-31-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 (CONTINUED)


CONDENSED
STATEMENT OF INCOME


For
the Years Ended December 31, 2008, 2007 and 2006


(In
thousands)





Table
      29: Condensed Income Statement
            
            2008
            
            
            2007
            
            
            2006Income:Dividends
      declared by bank subsidiary
            
            $
            650
            
            
            $
            -
            
            
            $
            250Interest
            
            
            15
            
            
            
            21
            
            
            
            12Total
      income
            
            
            665
            
            
            
            21
            
            
            
            262Expenses:Interest
      on subordinated debentures
            
            
            464
            
            
            
            702
            
            
            
            710Salaries
      and employee benefits
            
            
            99
            
            
            
            95
            
            
            
            92Professional
            
            
            95
            
            
            
            102
            
            
            
            78Other
      expenses
            
            
            227
            
            
            
            148
            
            
            
            67Total
      expenses
            
            
            885
            
            
            
            1,047
            
            
            
            947Loss
      before equity in undistributed income of subsidiary
            
            
            (220
            )
            
            
            (1,026
            )
            
            
            (685
            )Equity
      in undistributed income of subsidiary
            
            
            (5,328
            )
            
            
            5,153
            
            
            
            5,843(Loss)
      Income before income tax benefit
            
            
            (5,548
            )
            
            
            4,127
            
            
            
            5,158Income
      tax expense (benefit)
            
            
            (358
            )
            
            
            (422
            )
            
            
            (385
            )Net
      (loss) income
            
            $
            (5,190
            )
            
            $
            4,549
            
            
            $
            5,543




-32-
 PACIFIC
STATE BANCORP AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 (CONTINUED)


CONDENSED
STATEMENT OF CASH FLOWS
 For
the Years Ended December 31, 2008, 2007 and 2006
 (In
thousands)




Table
      30: Condensed Cash Flow
                                        
                                        2008
                                        
                                        
                                        2007
                                        
                                        
                                        2006Cash
      flows from operating activities:Net
      (loss) income
                                        
                                        $
                                        (5,190
                                        )
                                        
                                        $
                                        4,549
                                        
                                        
                                        $
                                        5,543Adjustments
      to reconcile net income (loss) to net cash provided by (used in) operating
      activities:Undistributed
      net loss (income) of subsidiary
                                        
                                        
                                        5,328
                                        
                                        
                                        
                                        (5,153
                                        )
                                        
                                        
                                        (5,843
                                        )Decrease
      (increase) in other assets
                                        
                                        
                                        1,497
                                        
                                        
                                        
                                        (529
                                        )
                                        
                                        
                                        (1,138
                                        )(Decrease)
      increase in other liabilities
                                        
                                        
                                        (14
                                        )
                                        
                                        
                                        61
                                        
                                        
                                        
                                        (20
                                        )Net
      cash provided by (used in) operating
                                          activities
                                        
                                        
                                        1,621
                                        
                                        
                                        
                                        (1,072
                                        )
                                        
                                        
                                        (1,458
                                        )Cash
      flows from investing activities:Proceeds
      from matured and called available-for-sale investment
      securities
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        204Proceeds
      from the retirement of Pacific State Statutory Trust
I
                                        
                                        
                                        -
                                        
                                        
                                        
                                        155
                                        
                                        
                                        
                                        -Investment
      in bank subsidiary
                                        
                                        
                                        (1,500
                                        )
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -Investment
      in Pacific State Statutory Trust III
                                        
                                        
                                        -
                                        
                                        
                                        
                                        (155
                                        )
                                        
                                        
                                        -Net
      cash provided by (used in) operatingactivities
                                        
                                        
                                        (1,500
                                        )
                                        
                                        
                                        -
                                        
                                        
                                        
                                        204Cash
      flows from financing activities:Proceeds
      from issuance of junior subordinated debentures
                                        
                                        
                                        -
                                        
                                        
                                        
                                        5,000
                                        
                                        
                                        
                                        -Retirement
      of junior subordinated debentures
                                        
                                        
                                        -
                                        
                                        
                                        
                                        (5,000
                                        )
                                        
                                        
                                        -Stock
      options exercised and related tax benefit
                                        
                                        
                                        349
                                        
                                        
                                        
                                        458
                                        
                                        
                                        
                                        1,616Proceeds
      from the issuance of common stock
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        250Net
      cash provided by financing activities
                                        
                                        
                                        349
                                        
                                        
                                        
                                        458
                                        
                                        
                                        
                                        1,866Increase
      (decrease) in cash and cash equivalents
                                        
                                        
                                        470
                                        
                                        
                                        
                                        (614
                                        )
                                        
                                        
                                        612Cash
      and cash equivalents at beginning of year
                                        
                                        
                                        -
                                        
                                        
                                        
                                        614
                                        
                                        
                                        
                                        2Cash
      and cash equivalents at end of year
                                        
                                        $
                                        470
                                        
                                        
                                        $
                                        -
                                        
                                        
                                        $
                                        614Non-cash
      investing activities:Net
      change in unrealized loss on available-for-sale investment
      securities
                                        
                                        $
                                        (1,911
                                        )
                                        
                                        $
                                        (565
                                        )
                                        
                                        $
                                        78


-33-





FORWARD
LOOKING STATMENTS





Certain statements discussed or
incorporated by reference in this Annual Report including, but not limited to,
information concerning possible or assumed future results of operations of the
Company set forth in the Management's Discussion and Analysis of Financial
Condition and Results of Operation, are forward-looking statements within the
meaning of the Securities Exchange Act of 1934 (the "Exchange Act").
Forward-looking statements include statements in which words such as "expect,"
"anticipate," "intend," "plan," "believe," "estimate," "consider" or variants or
similar expressions are used. The Company’s actual future results and
shareholder values may differ materially from those anticipated and expressed in
these forward-looking statements, which are based on management's beliefs and
assumptions and on information currently available to management, and are
subject to risks and uncertainties that could cause actual results to differ
materially from those projected. Such risks and uncertainties include, among
others, (1) competitive pressures in the banking industry; (2) changes in the
interest rate environment; (3) general economic conditions, either nationally or
regionally; (4) changes in the regulatory environment; (5) changes in business
conditions and inflation; and (6) changes in securities markets. Many of these
factors are beyond the Company’s ability to control or
predict.  Investors are cautioned not to put undue reliance on any
forward-looking statements.  In addition, the Company does not have
any intention or obligation to update forward-looking statements contained in
this Annual Report, even if new information, future events or other
circumstances have made them incorrect or misleading. Except as specifically
noted herein all references to the "Company" refer to Pacific State Bancorp, a
California corporation.




-34-


MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS





GENERAL
DESCRIPTION OF BUSINESS


Pacific
State Bancorp (the “Company”) is a holding company with one bank subsidiary,
Pacific State Bank, (the “Bank”), and two unconsolidated subsidiary grantor
trusts, Pacific State Statutory Trusts II and III.  Pacific State
Bancorp commenced operations on June 24, 2002 after acquiring all of the
outstanding shares of Pacific State Bank.  The Bank is a California
state chartered bank formed November 2, 1987. The Bank is a member of the
Federal Reserve System. The Bank’s primary source of revenue is interest on
loans to customers who are predominantly small to middle-market businesses and
middle-income individuals.  Pacific State Statutory Trusts II and III
are unconsolidated, wholly owned statutory business trusts formed in March 2004
and June 2007, respectively for the exclusive purpose of issuing and selling
trust preferred securities.


The Bank
conducts a general commercial banking business, primarily in the five county
region that comprises Alameda, Calaveras, San Joaquin, Stanislaus and Tuolumne
counties.  The Bank offers commercial banking services to residents
and employers of businesses in the Bank’s service area, including professional
firms and small to medium sized retail and wholesale businesses and
manufacturers.  The Company as of March 13, 2009 had 92 employees,
including 41 officers. The Bank does not engage in any non-bank lines of
business. The business of the Bank is not to any significant degree seasonal in
nature.  The Bank has no operations outside California and has no
material amount of loans or deposits concentrated among any one or few persons,
groups or industries.  The Bank operates nine branches with its
Administrative Office and one branch located at 1899 W. March Lane, in Stockton,
California; additional branches are located in Stockton and in the communities
of Angels Camp, Arnold, Groveland, Lodi, Modesto, Tracy and Hayward,
California.


Pacific
State Bancorp common stock trades on the NASDAQ Global Market under the symbol
of “PSBC”.





BUSINESS
PLAN


The focus
of the Company’s business plan is to attract “Business Relationship” small,
medium and large accounts, but not to the exclusion of any other business which
the Company can reasonably and profitably attract.  In order to
provide a level of service to attract such customers, the Company has structured
its specific services and charges on a basis which management believes to be
profitable, taking into consideration other aspects of the account
relationship.  The Company offers a full range of banking services to
its customers intended to attract the following specific types of accounts:
relatively large consumer accounts; professional group and association accounts,
including the accounts of groups or firms of physicians, dentists, attorneys and
accountants; and accounts of small to medium-sized businesses engaged in retail,
wholesale, light industrial, manufacturing, agricultural and service
activities.





TRUST
SUBSIDIARIES


The
Company during 2004 and 2007 established two subsidiary grantor
trusts.  Pacific State Statutory Trusts II and III (the
“Trusts”).  The Trusts were established for the sole purpose of
issuing capital securities (“Capital Securities”) pursuant to declarations of
trust (the “Declarations”).  The proceeds from the sale of the Capital
Securities were loaned to the Company as subordinated debentures (the
“Debentures”) issued to the Trusts pursuant to indentures (the
“Indentures”).  Interest payments on the Debentures will flow through
the Trusts to the Pooling Vehicles, which are the holders of the Capital
Securities and similar securities issued by other financial
institutions.  Payments of distributions by the Trusts to the Pooling
Vehicle are guaranteed by the Company. See Note 8 to the Company’s consolidated
financial statements included with this report.


Proceeds
from the issuance of the 2004 subordinated debentures were used to provide the
Bank with an additional $3.5 million in capital in order to support the
continued growth of the Bank.  Proceeds from the issuance of the 2007
subordinated debentures were used to retire the 2002 subordinated debenture
issuance.





-35-




PRODUCT
LINES AND SERVICES


The Bank
currently offers the following general banking services at all of its branches:
commercial, construction, agricultural and real estate loans and personal credit
lines, interest on checking, U.S. Savings bond services, domestic and foreign
drafts, banking by appointment, automatic transfer of funds between savings and
checking accounts, business courier services, checking and savings accounts for
personal and business purposes, domestic letters of credit, a depository for
MasterCard and Visa drafts, federal depository services, cash management
assistance, wire and telephone transfers, Individual Retirement Accounts, time
certificates of deposit, courier service for non-cash deposits, Visa and
MasterCard, revolving lines of credit to consumers secured by deeds of trust on
private residences, unsecured overdraft protection credit lines attached to
checking accounts,  ATM cards and MasterMoney debit cards via the
Star, Cirrus, Plus, MasterCard and Visa networks.


The Bank
is not authorized to offer trust services.  The Federal Reserve Bank
of San Francisco is the Company’s primary correspondent
relationship.  The Bank currently also has correspondent relationships
with City National Bank in Beverly Hills, California, First Tennessee Bank in
Memphis, Tennessee, Wells Fargo Bank, San Francisco, California and Pacific
Coast Bankers Bank, San Francisco, California.


The Bank
recognizes that, in order to be competitive, it must attract a certain number of
consumer accounts.  Individual Retirement Accounts, Visa and
MasterCard, revolving lines of credit to consumers secured by deeds of trust on
private residences, and unsecured overdraft protection credit lines attached to
checking accounts currently offered by the Bank are designed to appeal
particularly to consumers.  Moreover, participation in large-scale ATM
networks assists the Company in competing for consumer accounts.


The Bank
is an approved Small Business Administration and 504 lender, FSA, USDA Business
and Industry, USDA Part-time Farmer Program and FHA and VA
lender.  The Bank is a national leader in the underwriting of U.S.
Department of Agriculture business and industry loans, as well as a Preferred
Lender for this program.





CRITICAL
ACCOUNTING POLICIES





General


Pacific
State Bancorp’s consolidated financial statements are prepared in accordance
with accounting principles generally accepted in the United States of America
(GAAP). The financial information contained within our consolidated financial
statements is, to a significant extent, financial information that is based on
measures of the financial effects of transactions and events that have already
occurred. A variety of factors could affect the ultimate value that is obtained
either when earning income, recognizing an expense, recovering an asset or
relieving a liability. We use historical loss factors as one factor in
determining the inherent loss that may be present in our loan portfolio. Actual
losses could differ significantly from the historical factors that we
use.


Effective
January 1, 2006, the Company adopted Statement of Financial Accounting Standard
(“SFAS”) No. 123(R), “Share Based Payment”; see information under the header
“Share Based Compensation” in Note 2 to the consolidated financial statements
included with this report. Other estimates that we use are related to the
assumptions and estimates related to share based compensation, expected useful
lives of our depreciable assets and the determination whether any impairment
exists related to our investments and intangible and other long-lived
assets.  In addition, GAAP itself may change from one previously
acceptable method to another method. Although the economics of our transactions
would be the same, the timing of events that would impact our transactions could
change.


A
critical accounting estimate is one that requires a company to make assumptions
about matters that are highly uncertain at the time the accounting estimate is
made.  If different estimates that the company reasonably could have
used for the accounting estimate in the current period were made, or if changes
in the accounting estimate that are reasonably likely to occur from period to
period occurred, they could have a material impact on the presentation of the
company's financial condition, changes in financial condition or results of
operations.





Allowance
for Loan Losses


The
allowance for loan losses is an estimate of the losses that may be sustained in
our loan portfolio. The allowance is based on two basic principles of
accounting. (1) Statement of Financial Accountings Standards (SFAS) No. 5 "Accounting for
Contingencies", which requires that losses be accrued when they are
probable of occurring and estimable and (2) SFAS No. 114, "Accounting by Creditors for
Impairment of a Loan", which requires that losses on impaired loans be
accrued and measured based on the differences between the value of collateral,
present value of future cash flows or values that are observable in the
secondary market and the loan balance.  When a loan is not expected to
be repaid in accordance with its contractual terms.


-36-


Share
Based Compensation


Effective
January 1, 2006, the Company adopted Statement of Financial Accounting Standards
No. 123 (R), Share-Based Payment (“SFAS 123 (R)”). Under SFAS 123(R),
compensation cost recognized for all awards that vest subsequent to the date of
adoption based are on the grant-date fair value estimated in accordance with
SFAS No. 123, Accounting for Stock-Based Compensation and SFAS 123(R). The
grant-date fair value is estimated using the Black-Scholes-Merton option-pricing
formula, which involves making estimates of the assumptions used, including the
expected term of the option, expected volatility over the option term, expected
dividend yield over the option term and risk-free interest rate.  In
addition, when determining the compensation expense to amortize over the vesting
period, management makes estimates about the expected forfeiture rate of
options.





Securities


Debt
securities are classified based on management’s intention on the date of
purchase and recorded on the Consolidated Balance Sheet as debt securities as of
the trade date. Debt securities which management has the intent and ability to
hold to maturity are classified as held-to-maturity and reported at amortized
cost. Debt securities that are bought and held principally for the purpose of
resale in the near term are classified as trading account assets and are stated
at fair value with unrealized gains and losses included in trading account
profits (losses).  All other debt securities that management has the
intent and ability to hold for the foreseeable future are classified as
available-for-sale (AFS) and carried at fair value with net unrealized gains and
losses included in accumulated OCI on an after-tax basis. If there is an
other-than-temporary deterioration in the fair value of any individual debt
security classified as AFS, the Company will reclassify the associated net
unrealized loss out of accumulated OCI with a corresponding adjustment to other
income. If there is an other-than-temporary deterioration in the fair value of
any individual security classified as held-to-maturity the Company will write
down the security to fair value with a corresponding adjustment to other income.
Interest on debt securities, including amortization of premiums and accretion of
discounts, is included in interest income. Realized gains and losses from the
sales of debt securities, which are included in gains (losses) on sales of debt
securities, are determined using the specific identification
method.





RESULTS
OF OPERATIONS





Year
Ended December 31, 2008 Compared to Year Ended December 31, 2007


Net loss
for the year ended December 31, 2008, was $5,190,000 representing a decrease of
$9,739,000 or 214% over net income of $4,549,000 for the year ended December 31,
2007. The primary causes of the decrease in net income were the increase in the
provision for loan losses of $5,576,000 or 391% over 2007 levels, other than
temporary impairment charges of $8,923,000, and a loss on the sale of securities
of $1,291,000 which were not experienced in 2007.  In addition to the
increase in the provision for loan losses, other than temporary impairment
charges and losses on the sale of securities, noninterest expense increased by
$2,331,000, or 21%, over 2007 levels due primarily to increased legal and
professional fees associated with loan collections.


In 2008
the Company faced many difficult challenges with respect to its investment and
loan portfolios.  The Company took significant losses related to
Fannie Mae and Freddie Mac preferred stock positions.  The value of
the preferred stock positions were impaired after the United States Treasury
Department placed the organizations into receivership and canceled dividend
payments associated with the preferred stock.  The Company
subsequently sold the preferred stock at a realized loss of
$6,843,000.  The Company also recognized an impairment charge on a
single issue trust preferred security in the amount of $2,425,000 and
experienced other net realized losses of $946,000 in the investment
portfolio.


As the
economic environment has deteriorated, additional reserves were required for
loan losses.  The Company recorded $7,001,000 in provision for
additional loan losses in 2008.  The reserve for loan losses as of
December 31, 2008 was $6,019,000 or 1.95% of loans.


Despite
the Company’s losses, Pacific State Bancorp continued to achieve strong growth
in average earning assets, increasing by $28,373,000 or
8%.  Offsetting the growth in average earning assets was a decrease in
the average yield earned on average earning assets by 163 basis points or
19%.  In order to fund the growth in average earning assets, the
Company increased its average interest bearing liabilities by $28,407,000 or
9%.  The average rate paid on interest bearing liabilities decreased
by 88 basis points or 19%.  The decrease in the rate received on
average earning assets offset the growth in average earning assets which
resulted in decreased total interest earned by $3,967,000 or 13%.  The
Company experienced a similar result in interest bearing
liabilities.  The rate paid on average interest bearing liabilities
was large enough to offset the increase in interest bearing
liabilities.  The result was decreased interest expense of $1,602,000,
or 12%.  The net result is a decrease in net interest income of
$2,365,000 or 14%.  A more in depth discussion of average balances and
the rates received or paid on those balances is presented in the section titled
“Net
Interest Income” below.


Loss on
average assets (ROA) was 1.20% for the year ended 2008 while the return on
average assets was 1.13% for the year ended 2007.  The loss on average
equity (ROE) was 14.95% in 2008 compared with a return on average equity of
14.22% in 2007.  Diluted loss per share for 2008 was $1.40 compared to
diluted earnings per share of $1.14 in 2007, a decrease of 223%.  The
decrease in earnings per share was primarily due to the decrease in net income
of 214%.


The
Company’s average total assets increased to $433.5 million in 2008 or 7.7% over
$402.5 million in 2007.  The Company’s total assets decreased to
$421.5 million as of December 31, 2008 or 2.1% below $431.1 million at December
31, 2007.  Total gross loans decreased in 2008 to $308.0 million from
$312.4 million in 2007, a decrease of $4.4 million or 1.4%.  Total
deposits decreased to $341.0 million, or 0.25%, compared to $341.8 million in
2007.  The growth in the average balance sheet compared to an overall
decrease in the period end balance sheet is the result of growth in the middle
of 2008 with contraction at the end of the year.  The contraction at
the end of 2008 is the result of the poor economic environment in which the
Company operates.





-37-




Year
Ended December 31, 2007 Compared to Year Ended December 31, 2006


Net
income for the year ended December 31, 2007, was $4,549,000 representing a
decrease of $994,000 or 17.93% over net income of $5,543,000 for the year ended
December 31, 2006. The primary cause of the decrease in net income was the
increase in the provision for loan losses of $1,065,000 or $627,000 after the
recorded tax effect, over 2006 levels.  In addition to the increase in
the provision for loan losses, noninterest expense increased by $637,000, or
$375,000 after the recorded tax effect, over 2006 levels.  The
increase in noninterest expense is primarily attributable to the full year
recognition of expenses in 2007 related to the opening of two new branches in
late 2006.  In 2007 the Company achieved strong growth in average
earning assets, increasing by $63,105,000 or 21%.  The average yield
earned on average earning assets decreased by 23 basis points or
3%.  In order to fund the growth in average earning assets, the
Company increased its average interest bearing liabilities by $60,751,000 or
25%.  The average rate paid on interest bearing liabilities increased
by 78 basis points or 20%.  The growth in average earning assets
increased total interest earned by $4,747,000 or 18%, while the increase in
interest bearing liabilities increased interest expense by $4,654,000, resulting
in an increase of net interest income of $93,000.  A more in depth
discussion of average balances and the rates received or paid on those balances
is presented in the section titled “Net Interest
Income” below.


Return on
average assets (ROA) decreased to 1.13% while the return on average equity (ROE)
decreased to 14.22% in 2007 compared with 1.67% and 22.91%, respectively, in
2006. Diluted earnings per share for 2007 and 2006 were $1.14 and $1.41,
respectively, a decrease of 19.15%.  The decrease in earnings per
share was primarily due to the decrease in net income of 17.93%.


The
Company’s average total assets increased to $402.5 million in 2007 or 21.53%
over $331.2 million in 2006.  The Company’s total assets increased to
$431.1 million as of December 31, 2007 or 11.46% over $386.8 million at December
31, 2006.  Total gross loans increased in 2007 to $312.4 million from
$289.8 million in 2006, an increase of $22.6 million or 7.80%.  Total
deposits grew to $341.8 million, or 0.23%, compared to $341.0 million in 2006.
Total borrowings grew to $48.8 million, or 256.20%, compared to $13.7 million in
2006.  The increases in the balance sheet and, particularly in loans
and borrowings, were attributable to the continued growth of the
bank.





Net
Interest Income


The
primary source of income for the Company is net interest income. Net interest
income represents the excess of interest and fees earned on interest-earning
assets (loans, securities and federal funds sold) over the interest paid on
deposits and borrowed funds. Net interest margin is net interest income
expressed as a percentage of average earning assets.


Net
interest income decreased $2.4 million or 14% to $15.0 million in 2008 from
$17.4 million in 2007 and increased $93 thousand or 0.54% in 2007 from $17.3
million in 2006.  Total average earning assets increased $28.4 million
or 8% to $391.9 million from $363.5 million in 2008.  Average loan
balances outstanding during 2008 increased $22.3 million or 7%, while average
balances of investments, federal funds sold and interest bearing deposits in
banks increased by $6.1 million or 10%.  The average yield on loans in
2008 decreased by 167 basis points compared to 2007.  The average
yield on investments, federal funds sold and interest bearing deposits increased
138 basis points in 2008 compared to 2007.  The decrease in loan
yields is related to fluctuating market conditions based on economic data,
competition and the lagging effect of interest rate cuts.  As a result
of the change in mix of earning assets, the overall yield on average earning
assets during 2008 decreased 163 basis points to 6.96% from 8.59% for
2007.


Net
interest income increased $93 thousand or 0.54% to $17.4 million in 2007 from
$17.3 million in 2006 and $3.8 million or 27.86% in 2006 from $13.5 million in
2005.  Total average earning assets increased $63.1 million or 21.01%
to $363.5 million from $300.4 million in 2006.  Average loan balances
outstanding during 2007 increased $30.8 million or 11.45%, while average
balances of investments, federal funds sold and interest bearing deposits in
banks increased by $32.3 million or 104.00%.  The average yields on
loans in 2007 increased by 5 basis points.  The average yield on
investments, federal funds sold and interest bearing deposits increased 14 basis
points in 2007 compared to 2006.  The slight increase in yields is
related to fluctuating market conditions based on economic data, competition and
the lagging effect of prior year interest rate cuts.  As a result of
the change in mix of earning assets, the overall yield on average earning assets
during 2007 decreased 23 basis points to 8.59% from 8.82% for 2006.


Total
interest expense decreased $1.6 million or 12%, to $12.2 million in 2008, from
$13.8 million in 2007.  Total interest expense increased $4.7 million
or 51% to $13.8 million in 2007, from $9.2 million in 2006.  In 2008
the average balance of interest-bearing liabilities increased $28.4 million or
9% to $330.2 million from $301.8 million for the year ended December 31,
2007.  In 2007 the average balance of interest-bearing liabilities
increased $60.8 million or 25% to $301.8 million from $241.0 million for the
year ended December 31, 2006.  Additionally, the average rate paid on
interest-bearing liabilities decreased to 3.71% in 2008 from 4.59% in 2007 and
increased in 2007 from 3.81% in 2006.  The decrease in the average
interest rate paid on interest-bearing liabilities represents 88 basis points or
12% in 2008 and an increase of 78 basis points or 21% in 2007.


Average
interest-bearing demand deposits decreased $9.2 million or 11% to $78.1 million
in 2008 from $87.3 million in 2007.  The average rate paid on these
deposits during 2008 decreased 47 basis points.  Average certificates
of deposit increased $7.7 million or 4% to $207.9 million in 2008 from $200.2
million in 2007. The average rate paid on certificates of deposit during 2007
increased 83 basis points.  As a result of the increases in interest
rates described above and overall changes in the mix of interest-bearing
deposits, the average rate paid on all interest bearing deposits and borrowings
increased 78 basis points for 2007 to 4.59% from 3.81% in 2006.


The
following table sets forth the Company's daily average balance sheet, related
interest income or expense and yield or rate paid for the periods
indicated.  The yield on tax-exempt securities has not been adjusted
to a tax-equivalent yield basis. Average balances are based on daily
averages.


-38-





AVERAGE
BALANCES, INTEREST INCOME/EXPENSE AND YIELDS/RATES PAID





Table 31: Net Interest
Margin


For
      Year Ended December 31,(Dollars
      in thousands)Interest
                                                Average
                                                
                                                
                                                
                                                
                                                Interest
                                                
                                                Average
                                                
                                                
                                                
                                                
                                                
                                                Interest
                                                
                                                
                                                AverageAverage
                                                
                                                Income
      or
                                                Yield
      or
                                                
                                                
                                                Average
                                                
                                                Income
      or
                                                
                                                Yield
      or
                                                
                                                
                                                Average
                                                
                                                
                                                Income
      or
                                                
                                                
                                                Yield
      orAssets:
                                                Balance
                                                
                                                Expense
                                                Cost
                                                
                                                
                                                Balance
                                                
                                                Expense
                                                
                                                Cost
                                                
                                                
                                                Balance
                                                
                                                
                                                Expense
                                                
                                                
                                                CostInterest-earning
      assets:Loans
                                                $
                                                322,489
                                                
                                                $
                                                24,565
                                                
                                                7.62
                                                %
                                                
                                                $
                                                300,239
                                                
                                                $
                                                27,902
                                                
                                                
                                                9.29
                                                %
                                                
                                                $
                                                269,395
                                                
                                                
                                                $
                                                24,901
                                                
                                                
                                                
                                                9.24
                                                %Investment
      securities
                                                
                                                48,306
                                                
                                                
                                                2,290
                                                
                                                4.74
                                                %
                                                
                                                
                                                37,089
                                                
                                                
                                                2,033
                                                
                                                
                                                5.48
                                                %
                                                
                                                
                                                25,418
                                                
                                                
                                                
                                                1,321
                                                
                                                
                                                
                                                5.20
                                                %Federal
      funds sold
                                                
                                                20,057
                                                
                                                
                                                376
                                                
                                                1.87
                                                %
                                                
                                                
                                                25,115
                                                
                                                
                                                1,285
                                                
                                                
                                                5.12
                                                %
                                                
                                                
                                                5,602
                                                
                                                
                                                
                                                273
                                                
                                                
                                                
                                                4.87
                                                %Interest
      Bearing Deposits in Banks
                                                
                                                1,041
                                                
                                                
                                                44
                                                
                                                4.23
                                                %
                                                
                                                
                                                1,077
                                                
                                                
                                                22
                                                
                                                
                                                2.04
                                                %
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                0.00
                                                %Total
      average earning assets
                                                $
                                                391,893
                                                
                                                $
                                                27,275
                                                
                                                6.96
                                                %
                                                
                                                $
                                                363,520
                                                
                                                $
                                                31,242
                                                
                                                
                                                8.59
                                                %
                                                
                                                $
                                                300,415
                                                
                                                
                                                $
                                                26,495
                                                
                                                
                                                
                                                8.82
                                                %Non-earning
      assets:Cash
      and due from banks
                                                
                                                13,522
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                15,398
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                13,655Bank
      premises and equipment
                                                
                                                15,399
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                12,940
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                10,609Other
      assets
                                                
                                                16,629
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                13,322
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                9,058Allowance
      for loan loss
                                                
                                                (3,939
                                                )
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                (2,665
                                                )
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                (2,536
                                                )Total
      average assets
                                                $
                                                433,504
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                $
                                                402,515
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                $
                                                331,201Liabilities
      and Shareholders' Equity:Interest-bearing
      liabilities:DepositsInterest-bearing
      Demand
                                                $
                                                71,935
                                                
                                                $
                                                1,618
                                                
                                                2.25
                                                %
                                                
                                                $
                                                81,898
                                                
                                                $
                                                2,231
                                                
                                                
                                                2.72
                                                %
                                                
                                                $
                                                92,280
                                                
                                                
                                                $
                                                2,438
                                                
                                                
                                                
                                                2.64
                                                %Savings
                                                
                                                6,122
                                                
                                                
                                                42
                                                
                                                0.69
                                                %
                                                
                                                
                                                5,352
                                                
                                                
                                                46
                                                
                                                
                                                0.86
                                                %
                                                
                                                
                                                6,359
                                                
                                                
                                                
                                                56
                                                
                                                
                                                
                                                0.88
                                                %Time
      Deposits
                                                
                                                207,848
                                                
                                                
                                                8,765
                                                
                                                4.22
                                                %
                                                
                                                
                                                200,154
                                                
                                                
                                                10,567
                                                
                                                
                                                5.28
                                                %
                                                
                                                
                                                125,994
                                                
                                                
                                                
                                                5,608
                                                
                                                
                                                
                                                4.45
                                                %Other
      borrowing
                                                
                                                44,265
                                                
                                                
                                                1,815
                                                
                                                4.10
                                                %
                                                
                                                
                                                14,359
                                                
                                                
                                                998
                                                
                                                
                                                6.95
                                                %
                                                
                                                
                                                16,379
                                                
                                                
                                                
                                                1,086
                                                
                                                
                                                
                                                6.63
                                                %Total
      average interest-bearing liabilities
                                                $
                                                330,170
                                                
                                                $
                                                12,240
                                                
                                                3.71
                                                %
                                                
                                                $
                                                301,763
                                                
                                                $
                                                13,842
                                                
                                                
                                                4.59
                                                %
                                                
                                                $
                                                241,012
                                                
                                                
                                                $
                                                9,188
                                                
                                                
                                                
                                                3.81
                                                %Noninterest-bearing
      liabilities:Demand
      deposits
                                                
                                                64,242
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                64,242
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                64,593Other
      liabilities
                                                
                                                4,378
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                4,524
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                1,405Total
      average liabilities
                                                
                                                398,790
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                370,529
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                307,010Shareholders'
      equity:
                                                
                                                34,714
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                31,986
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                24,191Total
      average liabilities and shareholders' equity
                                                $
                                                433,504
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                $
                                                402,515
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                $
                                                331,201Net
      interest income
                                                
                                                
                                                
                                                $
                                                15,035
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                $
                                                17,400
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                $
                                                17,307Net
      interest margin
                                                
                                                
                                                
                                                
                                                
                                                
                                                3.84
                                                %
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                4.79
                                                %
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                5.76
                                                %
  -39-
  The
following table sets forth changes in interest income and expense for each major
category of earning assets and interest-bearing liabilities, and the amount of
change attributable to volume, rates and the combination of volume and rates
(mix) for the periods indicated.  The yield on tax-exempt securities
has not been adjusted to a tax-equivalent yield basis.





ANALYSIS
OF CHANGES IN NET INTEREST INCOME AND EXPENSE





Table
      32: Rate/Volume Table
            
            Years
      ended December 31,2008
      over 2007NetChange
            
            
            Rate(1)
            
            
            Volume(2)(In
      thousands)Interest
      Income:Loans
      and leases
            
            $
            (3,337
            )
            
            $
            (5,405
            )
            
            $
            2,068Investment
      securities
            
            
            257
            
            
            
            (358
            )
            
            
            615Federal
      funds sold
            
            
            (909
            )
            
            
            (650
            )
            
            
            (259
            )Interest
      bearing deposits in banks
            
            
            22
            
            
            
            23
            
            
            
            (1
            )Total
      interest income
            
            
            (3,967
            )
            
            
            (6,390
            )
            
            
            2,423Interest
      Expense:Interest-bearing
      demand
            
            
            (613
            )
            
            
            (342
            )
            
            
            (271
            )Savings
            
            
            (4
            )
            
            
            (11
            )
            
            
            7Time
      deposits
            
            
            (1,802
            )
            
            
            (2,208
            )
            
            
            406Other
      borrowing
            
            
            817
            
            
            
            (1,262
            )
            
            
            2,079Total
      interest expense
            
            
            (1,602
            )
            
            
            (3,822
            )
            
            
            2,220Net
      interest income
            
            $
            (2,365
            )
            
            $
            (2,568
            )
            
            $
            203





Table
      33: Rate/Volume Table
            
            Years
      ended December 31,2007
      over 2006NetChange
            
            
            Rate(1)
            
            
            Volume(2)(In
      thousands)Interest
      Income:Loans
      and leases
            
            $
            3,001
            
            
            $
            150
            
            
            $
            2,851Investment
      securities
            
            
            712
            
            
            
            105
            
            
            
            607Federal
      funds sold
            
            
            1,012
            
            
            
            61
            
            
            
            951Interest
      bearing deposits in banks
            
            
            22
            
            
            
            -
            
            
            
            22Total
      interest income
            
            
            4,747
            
            
            
            316
            
            
            
            4,431Interest
      Expense:Interest-bearing
      demand
            
            
            (207
            )
            
            
            67
            
            
            
            (274
            )Savings
            
            
            (10
            )
            
            
            (1
            )
            
            
            (9
            )Time
      deposits
            
            
            4,959
            
            
            
            1,658
            
            
            
            3,301Other
      borrowing
            
            
            (88
            )
            
            
            46
            
            
            
            (134
            )Total
      interest expense
            
            
            4,654
            
            
            
            1,770
            
            
            
            2,884Net
      interest income
            
            $
            93
            
            
            $
            (1,454
            )
            
            $
            1,547





(1)
            The
      rate change in net interest income represents the change in rate
      multiplied by the current year’s average
  balance.


(2)
            The
      volume change in net interest income represents the change in average
      balance multiplied by the current year’s
rate.




-40-






The
Company’s non-interest income normally consists primarily of service charges on
deposit accounts, gain on sale of loans and ATM and other service
fees.  For the year ended December 31, 2008, non-interest income
represented a reduction of 24% of the Company’s revenues versus a contribution
of 7% in 2007, and 9% in 2006.  In 2008 the Company’s non-interest
income was severely impacted by extraordinary negative activity.  The
Company recorded an other than temporary impairment charge on available for sale
securities of $8.9 million and a  loss on the sale of available for
sale securities of $1.3 million, reduced somewhat by a gain on the sale of
assets of $471 thousand and a gain on Company owned life insurance of $2.6
million.


Total
non-interest income decreased significantly to a net loss of $5.3 million in
2008 from a net gain of $2.5 million in 2007 which was a slight increase from
$2.6 million in 2006. Service charge income decreased $66 thousand or 7% to $823
thousand in 2008.  The decrease in service charges in 2008 was the
result of decreased account activity.  Service charge income increased
$25 thousand in 2007 or 3% to $889 thousand, up from $864 thousand for the
comparable period in 2006.  The increase in service charge income in
2007 was is the result of the increase in deposit accounts as a result of the
growth of the Company.  The increase in service charges in 2007 and
2006 was offset by a decrease in gain on sales of loans of $144 thousand or
49.98% between 2007 and 2006 and $515 thousand or 63.66% between 2006 and 2005.
The increase in the gain on sale of loans in 2008 and the decrease in 2007
compared to 2006 are due to both the timing of the sale of the loans and the
changes in the number and dollar amount of loans sold.  Other income
decreased $536 thousand to $890 thousand in 2008 over 2007 and increased $1
thousand or 1% in 2007 from $1,425 thousand in 2006.  Other income
decreased in 2008 compared to 2007 primarily because of a decrease in prepayment
penalties assessed on loans.  Other income remained constant in 2007
over 2006 levels.





The
following table sets forth a summary of non-interest income for the periods
indicated.




Table
      34: Noninterest Income
            
            Years
      Ended December 31,2008
            
            
            2007
            
            
            2006(In
      thousands)Service
      charges
            
            $
            823
            
            
            $
            889
            
            
            $
            864Gain
      on sale of
      loans
            
            
            188
            
            
            
            150
            
            
            
            294Gain
      on sale of
      assets
            
            
            471
            
            
            
            -
            
            
            
            -Gain
      on Company owned life
      insurance
            
            
            2,574
            
            
            
            -
            
            
            
            -Other
      income
            
            
            890
            
            
            
            1,426
            
            
            
            1,425Other
      than temporary impairment
      charge
            
            
            (8,923
            )
            
            
            -
            
            
            
            -Loss
      on sale of
      securities
            
            
            (1,291
            )
            
            
            -
            
            
            
            -Total
      non-interest
      income
            
            $
            (5,268
            )
            
            $
            2,465
            
            
            $
            2,583





NON-INTEREST
EXPENSE


Non-interest
expense consists of salaries and related employee benefits, occupancy and
equipment expenses, professional fees, appraisal fees, directors’ fees, postage,
stationery and supplies expenses, telephone expenses, data processing expenses,
advertising and promotion expense and other operating expenses. Non-interest
expense for 2008 was $13.3 million compared to $11.0 million for 2007 and $10.4
million in 2006, representing an increase of $2.3 million or 21% for 2008, and
$0.6 million or 6% for 2007.  The increase in salary and benefits in
2008 over 2007 of $210,000 was primarily the result of increased staffing levels
and decreased deferred costs recognized associated with loan
production.  The decrease of $143,000 in 2007 over 2006 levels was
primarily related to staff turnover, efficiencies realized on upgraded IT
systems and management focus on controlling increases in salaries and
benefits.  The increase in occupancy and equipment expense of $395
thousand in 2008 over 2007 is attributable to increased use of machines for
branch data capture, information technology upgrades and expensing of certain
assets no longer in use.  The increase in occupancy and equipment
expense of $236 thousand in 2007 over 2006 is attributable to the addition of
the new branches in Lodi and Hayward in 2006.  Data processing expense
increased by $97 thousand in 2008 over 2007 levels; the increase is primarily
attributable to increasing volumes of electronic clearing of paper check
items.  Data processing expense increased by $205 thousand in 2007
over 2006 levels; the increase was primarily attributable to the costs
associated with implementing electronic clearing of paper check
items.  Advertising expense decreased in 2008 due to a focus on
controlling costs and evaluating the effectiveness of prior years’
advertising.  Advertising expense increased in 2007 and 2006 due to a
focus on increasing market share and increased costs associated with retaining
customers.  The Company incurred expenses associated with other real
estate owned in 2008 due to the foreclosure and marketing of properties where a
borrower discontinued payments in agreement with loan terms.  Other
expense increased in 2008 over 2007 primarily due to deposit insurance
assessments, correspondent bank charges, armored car expense, loan collection
expense and other costs associated with the growth of the
Company.  Professional fees increased significantly, due to the
increase of legal costs associated with loan collection.  Other
expense increased in 2007 over 2006 primarily due to correspondent bank charges
and other costs associated with the growth of the Company.




-41-




The
following table sets forth a summary of non-interest expense for the periods
indicated.





Table
      35: Noninterest Expense
            
            Year
      Ended December 31,(In
      thousands)2008
            
            
            2007
            
            
            2006Salaries
      and employee benefits
            
            $
            5,546
            
            
            $
            5,336
            
            
            $
            5,479Occupancy
      and equipment
            
            
            2,283
            
            
            
            1,888
            
            
            
            1,652Professional
      fees
            
            
            1,253
            
            
            
            294
            
            
            
            349Appraisal
      fees
            
            
            262
            
            
            
            266
            
            
            
            337Directors
      fees
            
            
            321
            
            
            
            290
            
            
            
            274Postage,
      stationery and supplies
            
            
            272
            
            
            
            212
            
            
            
            184Telephone
            
            
            265
            
            
            
            251
            
            
            
            210Data
      processing
            
            
            588
            
            
            
            328
            
            
            
            286Advertising
      and promotion
            
            
            408
            
            
            
            564
            
            
            
            365Other
      real estate owned
            
            
            94
            
            
            
            -
            
            
            
            -Other
      operating expenses
            
            
            2,036
            
            
            
            1,568
            
            
            
            1,224Total
      noninterest expense
            
            $
            13,328
            
            
            $
            10,997
            
            
            $
            10,360




PROVISION
FOR INCOME TAXES


The
Company’s provision for income taxes includes both federal income and state
franchise taxes and reflects the application of federal and state statutory
rates to the Company’s net income before taxes.  The principal
difference between statutory tax rates and the Company’s effective tax rate is
the benefit derived from investing in tax-exempt securities and Company owned
life insurance. Increases and decreases in the provision for taxes primarily
reflect changes in the Company’s net income before tax.  The following
table reflects the Company’s tax provision and the related effective tax rate
for the periods indicated.





The
following table reflects the Company’s tax provision and the related effective
tax rate for the periods indicated.





Table
      36: Tax (Benefit) Provision
            
            Years
      Ended December 31,(Dollars
      in thousands)
            
            2008
            
            
            2007
            
            
            2006Tax
      (benefit from) provision
            
            $
            (5,372
            )
            
            $
            2,894
            
            
            $
            3,627Effective
      Tax Rate
            
            
            (50.9
            )%
            
            
            38.9
            %
            
            
            39.6
            %




-42-




FINANCIAL
CONDITION





Investment
Securities


The
Company classifies its investment securities as "held-to-maturity" or "available-for-sale" at the
time of investment purchase. Generally, all securities are purchased with the
intent and ability to hold them for long-term investment, and the Company has
both the ability and intent to hold “held-to-maturity” investments to maturity.
The Company does not engage in trading activities.


Investment securities held-to-maturity are carried
at cost adjusted for the accretion of discounts and amortization of premiums.
Securities available-for-sale may be
sold to implement the Company’s asset/liability management strategies and in
response to changes in interest rates, prepayment rates and similar factors.
Securities available-for-sale are recorded at fair value and unrealized gains or
losses, net of income taxes, are reported as accumulated other comprehensive
income or loss, in a separate component of shareholder's equity. Gain or loss on
sale of investment securities is based on the specific identification
method.


Investment securities held-to-maturity at December
31, 2008, consisted of mortgage-backed securities totaling $46 thousand with a
remaining contractual maturity of 6 to 14 years and a weighted-average yield to
maturity of 5.77%.





The
following table summarizes the contractual maturities of the Company’s
investment securities at their carrying value and their weighted-average yields
at December 31, 2008. The yield on tax-exempt securities has been adjusted to a
tax-equivalent yield basis.





Table
37: Investment Yields


(Dollars
      in thousands)
            
            Within
      One Year
            
            
            One
      to Five Years
            
            
            Five
      to Ten Years
            
            
            Over
      Ten Years
            
            
            TotalAmount
            
            
            Yield
            
            
            Amount
            
            
            Yield
            
            
            Amount
            
            
            Yield
            
            
            Amount
            
            
            Yield
            
            
            Amount
            
            
            YieldAvailable-for-sale
      securities:US
      Government Agencies and Treasuries
            
            $
            4,932
            
            
            
            2.09
            %
            
            $
            5,005
            
            
            
            2.32
            %
            
            $
            -
            
            
            
            -
            %
            
            $
            -
            
            
            
            -
            %
            
            $
            9,937
            
            
            
            2.21
            %Municipal
      Obligations
            
            
            205
            
            
            
            5.06
            %
            
            
            -
            
            
            
            -
            %
            
            
            168
            
            
            
            7.00
            %
            
            
            2,781
            
            
            
            6.98
            %
            
            
            3,154
            
            
            
            6.87
            %Corporate
      and Other Bonds
            
            
            -
            
            
            
            -
            %
            
            
            -
            
            
            
            -
            %
            
            
            -
            
            
            
            -
            %
            
            
            8,143
            
            
            
            6.16
            %
            
            
            8,143
            
            
            
            6.16
            %Mortgage-
      backed securities
            
            
            1
            
            
            
            7.00
            %
            
            
            435
            
            
            
            3.45
            %
            
            
            -
            
            
            
            -
            %
            
            
            21,919
            
            
            
            4.96
            %
            
            
            22,355
            
            
            
            4.93
            %Total
      available-for-sale securities
            
            
            5,138
            
            
            
            2.21
            %
            
            
            5,440
            
            
            
            2.41
            %
            
            
            168
            
            
            
            7.00
            %
            
            
            32,843
            
            
            
            5.43
            %
            
            
            43,589
            
            
            
            4.68
            %Held-to-maturity
      SecuritiesMortgage-backed
      securities
            
            $
            -
            
            
            
            -
            %
            
            $
            -
            
            
            
            -
            %
            
            $
            28
            
            
            
            6.20
            %
            
            $
            18
            
            
            
            5.09
            %
            
            $
            46
            
            
            
            5.77
            %





The
following table summarizes the carrying value of the Company’s investment
securities held on the dates indicated.





Table
      38: Investment Balances
            
            As
      of December 31,(Dollars
      in thousands)
            
            2008
            
            
            2007
            
            
            2006Available-for-sale
      securities – at fair value:U.S.
      Government agencies and treasuries
            
            $
            10,177
            
            
            $
            20,417
            
            
            $
            13,733Municipal
      obligations
            
            
            3,035
            
            
            
            3,161
            
            
            
            2,760Corporate
      and other bonds
            
            
            3,809
            
            
            
            9,592
            
            
            
            2,506Mortgage-
      backed securities
            
            
            22,671
            
            
            
            8,124
            
            
            
            4,035Total
      available-for-sale
            
            $
            39,692
            
            
            $
            41,294
            
            
            $
            23,034Held-to-maturity
      securities – at amortized cost:Mortgage-backed
      securities
            
            $
            46
            
            
            $
            58
            
            
            $
            73





As of
December 31, 2008, the aggregate book value of the Company’s investment in
securities of a single issuer did not exceed 10% of the company’s shareholders’
equity.





LOANS
AND ASSET QUALITY


The
Company concentrates its lending activities primarily within Alameda, Calaveras,
San Joaquin, Stanislaus and Tuolumne Counties.


The Company manages its credit risk
through diversification of its loan portfolio and the application of
underwriting policies and procedures and credit monitoring practices. Although
the Company has a diversified loan portfolio, a significant portion of its
borrowers' ability to repay the loans is dependent upon the professional
services and residential real estate development industry sectors. Generally,
the loans are secured by real estate or other assets and are expected to be
repaid from cash flows of the borrower or proceeds from the sale of
collateral.


-43-





The
following table sets forth the amounts of loans outstanding by category as of
the dates indicated:





Table
39: Loan Categories


(Dollars
      in thousands)
            
            As
      of December 31,2008
            
            
            2007
            
            
            2006
            
            
            2005
            
            
            2004Commercial
      and Agricultural
            
            $
            94,437
            
            
            $
            95,658
            
            
            $
            89,045
            
            
            $
            60,645
            
            
            $
            55,569Real
      estate-construction
            
            
            64,762
            
            
            
            80,168
            
            
            
            75,654
            
            
            
            43,352
            
            
            
            22,965Real
      estate-commercial mortgage
            
            
            135,013
            
            
            
            121,157
            
            
            
            112,532
            
            
            
            126,166
            
            
            
            109,895Installment
            
            
            13,609
            
            
            
            15,215
            
            
            
            12,526
            
            
            
            13,536
            
            
            
            13,121Deferred
      Loan Fees and Costs
            
            
            143
            
            
            
            208
            
            
            
            40
            
            
            
            213
            
            
            
            199Allowance
      for Loan Losses
            
            
            (6,019
            )
            
            
            (3,948
            )
            
            
            (2,478
            )
            
            
            (2,356
            )
            
            
            (2,214
            )Total
      Net Loans
            
            $
            301,945
            
            
            $
            308,458
            
            
            $
            287,318
            
            
            $
            241,556
            
            
            $
            199,535





Net loans
have decreased $6.5 million or 2%, to $302.0 million at December 31, 2008 from
$308.5 million at December 31, 2007.  The Company’s loan portfolio
contracted in the commercial and agricultural categories by $1.2 million or 1%
in 2008.  Real estate construction loans have decreased $15.4 million
or 19%, real estate commercial mortgage loans increased $13.9 million or 11% and
installment loans have decreased $1.6 million or 11% in 2008.  The
portfolio mix has changed in 2008 as compared with the mix of the previous year:
while commercial and agricultural loans remained at 31% in 2008, real estate
construction loans decreased to 21% compared to 26% in 2007, real estate -
commercial mortgage loans increased to 44%, compared to 39% and installment
loans remained at 4% in 2008.  The shift in the mix reflects the
changes in lending needs within the Company’s service area.  In
addition, the Company has reclassified loans from real estate – construction to
real estate – commercial mortgage as construction projects are completed and a
permanent loan is provided.  The overall change in the mix of the loan
portfolio did not significantly impact the overall risk profile in the loan
portfolio.


The following table sets forth the
maturity distribution of the Company’s commercial and agricultural loans and
construction loans outstanding as of December 31, 2008, which, based on
remaining scheduled repayments of principal, were due within the periods
indicated.





Table
40: Commercial, Agriculture and Construction Loan Maturities


(Dollars
      in thousands)
            
            Within
      One Year
            
            
            After
      One through Five Years
            
            
            After
      Five Years
            
            
            TotalCommercial
      and agricultural
      loans
            
            $
            40,642
            
            
            $
            32,070
            
            
            $
            21,725
            
            
            $
            94,437Construction
      Loans
            
            
            54,522
            
            
            
            7,070
            
            
            
            3,170
            
            
            
            64,762Total
            
            $
            95,164
            
            
            $
            39,140
            
            
            $
            24,895
            
            
            $
            159,199Loans
      due after one year with:Fixed
      Rates
            
            
            $
            29,570
            
            
            $
            5,736
            
            
            $
            35,306Variable
      Rates
            
            
            $
            9,570
            
            
            $
            19,159
            
            
            $
            28,729





The
Company’s practice is to place a loan on nonaccrual status when one of the
following events occurs:(i) Any installment of principal or interest is 90 days
or more past due (unless in management's opinion the loan is well-secured and in
the process of collection), (ii) management determines the ultimate collection
of principal or interest to be unlikely or (iii) the terms of the loan have been
renegotiated due to a serious weakening of the borrower's financial condition.
Nonperforming loans are loans that are on nonaccrual, are 90 days past due and
still accruing or have been restructured.


-44-





The
following table sets forth a summary of the Company’s nonperforming loans and
other assets as of the dates indicated:





Table
41: Nonperforming Assets


As
      of December 31,(Dollars
      in Thousands)
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005
            
            
            2004Nonaccrual
      loans
            
            $
            23,560
            
            
            $
            432
            
            
            $
            --
            
            
            $
            --
            
            
            $
            --90
      days past due and still accruing interest
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --Other
      Real Estate
      Owned
            
            $
            2,029
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --





The
Company had a total of eleven loans on nonaccrual at December 31,
2008.  Three loans accounted for $17 million or 72% of the total
balance of nonaccrual loans.  In each case, the Company holds
commercial real estate as collateral and in one case holds a single family
residence as collateral in addition to the commercial real
estate.  The Company had one nonaccrual loan as of December 31, 2007
and did not have any nonaccrual loans at December 31, 2006.





ALLOWANCE
FOR LOAN LOSSES (ALL)


In
determining the amount of the Company’s Allowance for Loan Losses (“ALL”),
management assesses probable loss characteristics of the loan portfolio
including the concentrations, nature and diversification of the portfolio. Each
credit is assigned a credit risk rating factor, and this factor, multiplied by
the dollars associated with the credit risk rating, is used to calculate one
component of the ALL. In addition, management estimates the probable loss on
individual credits that are receiving increased management attention due to
identified increases in credit risk.  Management reviews the credit
risk report with the Directors Loan Committee as well as with the full Board of
Directors, monthly.


The adequacy of the ALL is calculated
upon three components. First is the credit risk rating of the loan portfolio,
including all outstanding loans.  Every extension of credit has been
assigned a risk rating based upon a comprehensive definition intended to measure
the inherent risk of lending money. Each rating has an assigned risk factor
expressed as a reserve percentage. Central to this assigned risk factor is the
historical loss record of the Company. Secondly, established specific reserves
are available for individual loans currently on management's watch and
classified loan lists. These are the estimated potential losses associated with
specific borrowers based upon the collateral and event(s) causing the risk
ratings. The third component is unallocated. This reserve is for qualitative
factors that may affect the portfolio as a whole, such as those factors
described below.  Management believes the assigned risk grades and our
methods for managing risk are satisfactory.


The Company makes provisions to the ALL
on a regular basis through charges to operations that are reflected in the
Company’s statements of income as a provision for loan losses. When a loan is
deemed uncollectible, it is charged against the allowance. Any recoveries of
previously charged-off loans are credited back to the allowance. There is no
precise method of predicting specific losses or amounts that ultimately may be
charged-off on particular categories of the loan portfolio. Similarly, the
adequacy of the ALL and the level of the related provision for probable loan
losses is determined on a judgment basis by management based on consideration of
a number of factors including (i) economic conditions, (ii) borrowers' financial
condition, (iii) loan impairment, (iv) evaluation of industry trends, (v)
industry and other concentrations, (vi) loans which are contractually current as
to payment terms but demonstrate a higher degree of risk as identified by
management, (vii) continuing evaluation of the performing loan portfolio, (viii)
monthly review and evaluation of problem loans identified as having a loss
potential, (ix) monthly review by the Board of Directors, and (x) assessments by
regulators and other third parties. Certain members of Management and the Board
of Directors evaluate the allowance and determine its desired level considering
objective and subjective measures, such as knowledge of the borrowers'
businesses, valuation of collateral, the determination of impaired loans and
exposure to potential losses.


While management uses available
information to recognize losses on loans, future additions to the allowance may
be necessary based on changes in economic conditions and other qualitative
factors. In addition, various regulatory agencies, as an integral part of their
examination process, periodically review the Company’s ALL. Such agencies may
require the Company to provide additions to the allowance based on their
judgment of information available to them at the time of their examination.
There is uncertainty concerning future economic trends. Accordingly it is not
possible to predict the effect future economic trends may have on the level of
the provision for possible loan losses in future periods.


The Company’s principal lines of
lending are (i) commercial and agricultural, (ii) real estate construction and
(iii) commercial and residential real estate. The primary sources of repayment
of the Company’s commercial loans are the borrowers' conversion of short-term
assets to cash and operating cash flow. The net assets of the borrower or
guarantor are usually identified as a secondary source of repayment. The
principal factors affecting the Company’s risk of loss from commercial lending
include each borrower's ability to manage its business affairs and cash flows,
local and general economic conditions and real estate values in the Company’s
service area. The Company manages its commercial loan portfolio by monitoring
its borrowers' payment performance and their respective financial condition and
makes periodic adjustments, if necessary, to the risk grade assigned to each
loan in the portfolio. The Company’s evaluations of its borrowers are
facilitated by management's knowledge of local market conditions and periodic
reviews by a consultant of the Company’s credit administration
policies.


The principal source of repayment of
the Company’s real estate construction loans is the sale of the underlying
collateral or the availability of permanent financing from the Company or other
lending source. The principal risks associated with real estate construction
lending include project cost overruns and deterioration of real estate values as
a result of various factors, including competitive pressures and economic
downturns. The Company manages its credit risk associated with real estate
construction lending by establishing loan-to-value ratios and loan-to-cost
ratios on projects on an as-completed basis, inspecting project status in
advance of controlled disbursements and matching maturities with expected
completion dates. Generally, the Company requires a loan-to-value ratio of not
more than 80% on single family residential construction loans.


The principal source of repayment of
the Company’s real estate mortgage loans is the borrowers' operating cash flow.
Similar to commercial loans, the principal factors affecting the Company’s risk
of loss in real estate mortgage lending include each borrower’s ability to
manage its business affairs and cash flows, local and general economic
conditions and real estate values in the Company’s service area. The Company
manages its credit risk associated with real estate mortgage lending primarily
by establishing maximum loan-to-value ratios and using strategies to match the
borrower's cash flow to loan repayment terms.


The Company’s specific underwriting
standards and methods for each of its principal lines of lending include
industry-accepted analysis and modeling and certain proprietary techniques. The
Company’s underwriting criteria are designed to comply with applicable
regulatory guidelines, including required loan-to-value ratios. The Company’s
credit administration policies contain mandatory lien position and debt service
coverage requirements, and the Company generally requires a guarantee from 20%
or more owners of its corporate borrowers.


The ALL should not be interpreted as an
indication that charge-offs in future periods will occur in the stated amounts
or proportions.


-45-


The
following table summarizes the Company’s loan loss experience as well as
provisions and charges to the allowance for loan losses and certain ratios for
the periods indicated:





Table
42: Allowance for Loan Loss Activity


(Dollars
      in thousands)
            
            Years
      Ended December 31,2008
            
            
            2007
            
            
            2006
            
            
            2005
            
            
            2004Beginning
      Balance:
            
            $
            3,948
            
            
            $
            2,478
            
            
            $
            2,356
            
            
            $
            2,214
            
            
            $
            1,653Provision
      for loan losses
            
            
            7,001
            
            
            
            1,425
            
            
            
            360
            
            
            
            35
            
            
            
            504Charge-offs:Commercial
            
            
            (1,905
            )
            
            
            (143
            )
            
            
            (10
            )
            
            
            -
            
            
            
            (9
            )Real
      Estate
            
            
            (3,266
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Other
            
            
            (697
            )
            
            
            (18
            )
            
            
            (14
            )
            
            
            (17
            )
            
            
            -Total
      Charge-offs
            
            
            (5,868
            )
            
            
            (161
            )
            
            
            (24
            )
            
            
            (17
            )
            
            
            (9
            )Recoveries:Commercial
            
            
            925
            
            
            
            203
            
            
            
            -
            
            
            
            124
            
            
            
            66Other
            
            
            13
            
            
            
            3
            
            
            
            1
            
            
            
            -
            
            
            
            -Total
      Recoveries
            
            
            938
            
            
            
            206
            
            
            
            1
            
            
            
            124
            
            
            
            66Reclassification
      of the reserve for unfunded commitments
            
            
            -
            
            
            
            -
            
            
            
            (215
            )
            
            
            -
            
            
            
            -Ending
      Balance
            
            $
            6,019
            
            
            $
            3,948
            
            
            $
            2,478
            
            
            $
            2,356
            
            
            $
            2,214ALL
      to total loans
            
            
            1.95
            %
            
            
            0.86
            %
            
            
            0.98
            %
            
            
            1.10
            %
            
            
            1.05
            %Net
      charge-offs (recoveries) to average loans
            
            
            1.53
            %
            
            
            0.01
            %
            
            
            (.01
            )
      %
            
            
            (.03
            )
      %
            
            
            .12
            %





The
provision for loan losses was $7,001,000 for 2008 compared to $1,425,000 for
2007 and $360,000 for 2006. The increase of $5,576,000 in the provision for loan
losses in 2008 over 2007 reflected a severe economic downturn in the region
there the Company operates.  The region has experienced declining real
estate values which have left certain construction loans with a loan-to-value of
greater than 100%.  In those cases where the loan is dependent on the
collateral to repay the loan, the Company has charged-off loan principal to
bring the loan back into compliance with policy.  In other cases, the
value of the collateral has decreased below the principal on the loan, but cash
flows from business operations are expected to repay the loan.  In
these cases the business is evaluated to determine if there are sufficient cash
flows available through business operations to repay the loan.  If
operating cash flow has deteriorated, additional reserve is recorded against the
loan.  The increase of $1,065,000 in the provision for loan losses, in
2007 over 2006 represented potential losses from specific customers and not
degradation of overall credit quality in the loan portfolio.  The
Company recorded net charge-offs of $4,930,000 or 1.53% of average loans during
2008.  Net (recoveries) charge-offs were $(45,000) or .02% of average
loans for 2007 compared to $23,000 or .01% of average loans for
2006.





The
following table summarizes the allocation of the allowance for loan losses (ALL)
by loan type and the loans as a percent of loans outstanding in each loan
category at the dates indicated





Table
43: Allocation of Allowance for Loan Loss


(Dollars
      in thousands)2008
            
            
            
            
            
            2007
            
            
            
            
            
            2006
            
            
            
            
            
            2005
            
            
            
            
            
            2004Commercial
      and Agricultural
            
            $
            1,428
            
            
            
            30.68
            %
            
            $
            1,584
            
            
            
            30.77
            %
            
            $
            1,086
            
            
            
            25.82
            %
            
            $
            994
            
            
            
            24.89
            %
            
            $
            880
            
            
            
            27.57
            %Real
      estate – construction
            
            
            2,882
            
            
            
            21.04
            %
            
            
            757
            
            
            
            25.68
            %
            
            
            269
            
            
            
            26.11
            %
            
            
            196
            
            
            
            17.79
            %
            
            
            115
            
            
            
            11.39
            %Real
      estate – commercial
            
            
            1,312
            
            
            
            43.86
            %
            
            
            563
            
            
            
            39.58
            %
            
            
            642
            
            
            
            44.01
            %
            
            
            501
            
            
            
            51.77
            %
            
            
            422
            
            
            
            54.52
            %Installment
            
            
            246
            
            
            
            4.42
            %
            
            
            293
            
            
            
            3.97
            %
            
            
            279
            
            
            
            4.06
            %
            
            
            300
            
            
            
            5.55
            %
            
            
            308
            
            
            
            6.52
            %Unallocated
            
            
            151
            
            
            
            -
            
            
            
            751
            
            
            
            -
            
            
            
            202
            
            
            
            -
            
            
            
            365
            
            
            
            -
            
            
            
            489
            
            
            
            -Total
            
            $
            6,019
            
            
            
            100.00
            %
            
            $
            3,948
            
            
            
            100.00
            %
            
            $
            2,478
            
            
            
            100.00
            %
            
            $
            2,356
            
            
            
            100.00
            %
            
            $
            2,214
            
            
            
            100.00
            %





-46-




DEPOSITS


The
Company primarily obtains deposits from local businesses and professionals as
well as through certificates of deposit, savings and checking
accounts.





The
following table sets forth the remaining maturities of certificates of deposit
at December 31, 2008





Table
      44: Deposit Maturity Schedule(Dollars
      in thousands)
            
            Under $100,000
            
            
            Over $100,000Three
      Months or less
            
            $
            16,947
            
            
            $
            40,845Over
      three through six months
            
            
            23,617
            
            
            
            30,145Over
      six through twelve months
            
            
            26,542
            
            
            
            33,458Over
      twelve months
            
            
            7,982
            
            
            
            8,966Total
            
            $
            75,088
            
            
            $
            113,414





LIQUIDITY
AND MARKET RISK


The
purpose of liquidity management is to ensure efficient and economical funding of
the Company’s assets consistent with the needs of the Company’s depositors and,
to a lesser extent, shareholders. This process is managed not by formally
monitoring the cash flows from operations, investing and financing activities as
described in the Company’s statement of cash flows, but through an understanding
principally of depositor and borrower needs. As loan demand increases, the
Company can use asset liquidity from maturing investments along with deposit
growth to fund the new loans.


With respect to assets, liquidity is
provided by receipts from cash and money market investments such as
interest-bearing time deposits, federal-funds sold, available-for-sale
investment securities, and by principal and interest payments on loans. With
respect to liabilities, liquidity is provided by core deposits, shareholders'
equity and the ability of the Company to borrow funds and to generate
deposits.


Because estimates of the liquidity
needs of the Company may vary from actual needs, the Company maintains a
substantial amount of liquid assets to absorb short-term increases in loans or
reductions in deposits. As loan demand decreases or loans are paid off,
investment assets can absorb these excess funds or deposit rates can be
decreased to run off excess liquidity. Therefore, there is some correlation
between financing activities associated with deposits and investing activities
associated with lending. The Company’s liquid assets (cash and due from banks,
federal funds sold, interest bearing deposits in banks and available-for-sale
investment securities) totaled $78.2 million or 19% of total assets at December
31, 2008, $89.9 million or 21% of total assets at December 31, 2007 and $73.7
million or 19% of total assets at December 31, 2006. The Company expects that
its primary source of liquidity will be earnings of the Company, acquisition of
core deposits, and wholesale borrowing arrangements.





MARKET
RISK


Market
risk is the risk of loss in a financial instrument arising from adverse changes
in market rates and processes such as interest rates, commodity prices and
equity prices.  As typical for a financial institution, the Company’s
market risk arises primarily from interest rate risk
exposure.  Fluctuation in interest rates will ultimately impact both
the level of income and expense recorded on a large portion of the Company’s
assets and liabilities, and the market value of all interest earning assets and
interest bearing liabilities, other than those that possess a short term to
maturity.  Based upon the nature of its operations, the Company is not
subject to foreign currency exchange or commodity pricing.  However,
the Company’s commercial real estate loan portfolio, concentrated primarily in
Northern California, is subject to risks associated with the local
economies.


The fundamental objective of the
Company’s management of its assets and liabilities is to maximize the economic
value of the Company while maintaining adequate liquidity and managing exposure
to interest rate risk deemed by management to be
acceptable.  Management believes an acceptable degree of exposure to
interest rate risk results from management of assets and liabilities through
using floating rate loans and deposits, maturities, pricing and mix to attempt
to neutralize the potential impact of changes in market interest
rates.  The Company’s profitability is dependent to a large extent
upon its net interest income, which is the difference between its interest
income on interest earning assets, such as loans and securities, and interest
expense on interest bearing liabilities, such as deposits, trust preferred
securities and other borrowings.  The Company, like other financial
institutions, is subject to interest rate risk to the degree that its interest
earning assets reprice differently from its interest bearing
liabilities.  The Company manages its mix of assets and liabilities
with the goal of limiting exposure to interest rate risk, ensuring adequate
liquidity, and coordinating its sources and uses of funds.


The Company seeks to control its
interest rate risk exposure in a manner that will allow for adequate levels of
earnings and capital over a range of possible interest rate
environments.  The Company has adopted formal policies and practices
to monitor and manage interest rate exposure.  As part of this effort,
the Company measures interest rate risk utilizing both an internal asset
liability measurement system as well as independent third party reviews to
confirm the reasonableness of the assumptions used to measure and report the
Company’s interest rate risk, enabling management to make any adjustments
necessary.


Interest rate risk is managed by the
Company’s Asset Liability Committee (“ALCO”), which includes members of senior
management and several members of the Board of Directors.  The ALCO
monitors interest rate risk by analyzing the potential impact on interest income
from potential changes in interest rates and considers the impact of alternative
strategies or changes in balance sheet structure.  The ALCO manages
the Company’s balance sheet in part to maintain the potential impact on net
interest income within acceptable ranges despite changes in interest
rates.  The Company’s exposure to interest rate risk is reviewed on a
quarterly basis by the ALCO.





-47-




NET
INTEREST INCOME SIMULATION


In order
to measure interest rate risk at December 31, 2008, the Company used a
simulation model to project changes in net interest income that result from
forecasted projection and changes in interest rates.  This analysis,
which is performed quarterly by management, calculates the difference between
net interest income forecasted using a rising and falling interest rate scenario
and net interest income forecasted using a base market derived from the current
interest rates.  The income simulation model includes various
assumptions regarding the re-pricing relationships for each of the Company’s
products.  Many of the Company’s assets are floating rate loans, which
are assumed to reprice immediately and to the same extent as the change in
market rates according to their contracted index.  The Company’s
non-term deposit products reprice more slowly, usually changing less than the
change in market rates and at the discretion of the Company.


The analysis indicates the impact of
changes in net interest income for the given set of rate changes and
assumptions.  It assumes that the balance sheet grows modestly, but
that its structure will remain similar to the structure at
year-end.  It does not account for all factors that impact this
analysis, including the potential impact of loan prepayments, deposit drifts or
other balance sheet movements including changes by management to mitigate the
impact of interest rate changes or secondary impacts such as changes to the
Company’s credit risk profile as interest rates change.  Changes that
vary significantly from the assumptions may have significant effects on the
Company’s net interest income.





The
following table reflects the Company’s projected net interest income sensitivity
analysis based on year-end data:





Table
      45: Interest Income Sensitivity
            
            December
      31, 2008Change
      in Rates
            
            Adjusted
      Net Interest Income
            
            
            Percent
      Change From Base(In
      thousands)Up
      200 basis points
            
            $
            14,785
            
            
            
            (1.47
            )%Up
      150 basis points
            
            $
            14,848
            
            
            
            (1.05
            )%Up
      100 basis points
            
            $
            14,911
            
            
            
            (0.63
            )%Base
      Scenario
            
            $
            15,005
            
            
            
            0.00
            %Down
      100 basis points
            
            $
            15,152
            
            
            
            0.98
            %Down
      150 basis points
            
            $
            15,236
            
            
            
            1.54
            %Down
      200 basis points
            
            $
            15,324
            
            
            
            2.13
            %




-48-


CONTRACTUAL
OBLIGATIONS





The
following table summarizes the contractual obligations of the Company as of
December 31, 2008:





Table
      46: Contractual Obligations
            
            
            
            
            Less
      than
            
            
            
            
            
            
            
            
            More
      thanTotal
            
            
            one
      year
            
            
            1-3
      years
            
            
            3-5
      years
            
            
            5
      yearsSubordinated
      Debentures, floating rateof
      4.66% payable March 17, 2034
            
            $
            3,609
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            3,609Subordinated
      Debentures, floating rateof
      3.45% payable September 16, 2037
            
            
            5,155
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            5,155FHLB
      Loans weighted average fixed rate of 3.10%
            
            
            40,000
            
            
            
            11,000
            
            
            
            27,000
            
            
            
            2,000
            
            
            
            -Operating
      lease obligations
            
            
            1,701
            
            
            
            274
            
            
            
            404
            
            
            
            430
            
            
            
            593Salary
      continuation program (1)
            
            
            1,106
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            1,106Total
            
            $
            51,571
            
            
            $
            11,274
            
            
            $
            27,404
            
            
            $
            2,430
            
            
            $
            10,463


(1)
            Salary
      continuation program obligations represent the amount accrued as of
      December 31, 2008 under the terms of the
  program.





In
addition to those obligations listed above, in the normal course of business,
the Company will make cash distributions for, among other items, the payment of
interest on interest bearing deposit accounts and debt obligations, payments for
quarterly tax estimates and contributions to certain employee benefit
plans.





CAPITAL
RESOURCES


Capital
adequacy is a measure of the amount of capital needed to sustain asset growth
and act as a cushion for losses. Capital protects depositors and the Federal
deposit insurance fund from potential losses and is a source of funds for the
investments the Company needs to remain competitive.  Historically,
capital has been generated principally from the retention of
earnings.


Overall capital adequacy is monitored
on a day-to-day basis by the Company’s management and reported to the Company’s
Board of Directors on a quarterly basis.  The Bank’s regulators
measure capital adequacy by using a risk-based capital framework and by
monitoring compliance with minimum leverage ratio guidelines. Under the
risk-based capital standard, assets reported on the Company’s balance sheet and
certain off-balance sheet items are assigned to risk categories, each of which
is assigned a risk weight.


This
standard characterizes an institution's capital as being "Tier 1" capital
(defined as principally comprising shareholders' equity and qualifying
subordinated debentures ) and "Tier 2" capital (defined as principally
comprising the qualifying portion of subordinated debt and the qualifying
portion of the ALL), the total amount not to exceed 100% of Tier 1
capital.


The minimum ratio of total
risk-based capital to risk-adjusted assets, including certain off-balance sheet
items, is 8%.


At December 31, 2008, 2007 and 2006 the
Company’s capital met all minimum regulatory requirements.


As of December 31, 2008, the most
recent notification by the Federal Depository Insurance Corporation (FDIC)
categorized the Bank as well capitalized under the regulatory framework for
prompt corrective action.  To be categorized as well capitalized the
Bank must meet the minimum ratios as set forth below. There are no conditions or
events since that notification that management believes have changed the
institution’s category.  For more information on the Company’s and the
Bank’s risk-based capital ratios, see note 11 to the Financial Statements
contained in this report.





IMPACT
OF INFLATION


Inflation
affects the Company’s financial position as well as its operating results. It is
management's opinion that the effects of inflation on the financial statements
have not been material.




-49-


QUARTERLY
FINANCIAL INFORMATION (UNAUDITED)





The
following table presents the summary unaudited results for the stated eight
quarters:





Table
47: Quarterly Financial Results


2008
            
            
            2007(In
      thousands, except per share data)
            
            4thQuarter
            
            
            3rdQuarter
            
            
            2ndQuarter
            
            
            1st
              Quarter
            
            
            4thQuarter
            
            
            3rdQuarter
            
            
            2ndQuarter
            
            
            1st
              QuarterDiluted
      (loss) earnings per share
            
            $
            (1.52
            )
            
            $
            (0.30
            )
            
            $
            0.15
            
            
            $
            0.27
            
            
            $
            0.13
            
            
            $
            0.33
            
            
            $
            0.35
            
            
            $
            0.33Basic
      (loss) earnings per share
            
            $
            (1.52
            )
            
            $
            (0.32
            )
            
            $
            0.16
            
            
            $
            0.30
            
            
            $
            0.14
            
            
            $
            0.35
            
            
            $
            0.38
            
            
            $
            0.36Interest
      income
            
            $
            5,792
            
            
            $
            6,948
            
            
            $
            7,234
            
            
            $
            7,301
            
            
            $
            7,667
            
            
            $
            7,937
            
            
            $
            8,132
            
            
            $
            7,506Net
      interest
      income
            
            $
            3,220
            
            
            $
            4,048
            
            
            $
            3,848
            
            
            $
            3,919
            
            
            $
            4,175
            
            
            $
            4,241
            
            
            $
            4,653
            
            
            $
            4,331Provision
      for loan losses
            
            $
            5,591
            
            
            $
            600
            
            
            $
            600
            
            
            $
            210
            
            
            $
            1,165
            
            
            $
            40
            
            
            $
            55
            
            
            $
            165Total
      non-interest (loss) income
            
            $
            (3,400
            )
            
            $
            (2,937
            )
            
            $
            597
            
            
            $
            472
            
            
            $
            484
            
            
            $
            589
            
            
            $
            706
            
            
            $
            686Total
      non-interest expense
            
            $
            4,450
            
            
            $
            3,558
            
            
            $
            2,825
            
            
            $
            2,495
            
            
            $
            2,585
            
            
            $
            2,711
            
            
            $
            3,002
            
            
            $
            2,699(Loss)
      Income before taxes
            
            $
            (10,221
            )
            
            $
            (3,047
            )
            
            $
            1,020
            
            
            $
            1,686
            
            
            $
            909
            
            
            $
            2,079
            
            
            $
            2,313
            
            
            $
            2,142Net
      (loss)
      Income
            
            $
            (5,654
            )
            
            $
            (1,209
            )
            
            $
            579
            
            
            $
            1,094
            
            
            $
            513
            
            
            $
            1,301
            
            
            $
            1,409
            
            
            $
            1,326




-50-





MARKET PRICE FOR REGISTRANT’S COMMON EQUITY, DIVIDENDS AND
RELATED STOCKHOLDER MATTERS








The
Company’s common stock is listed for trading on the NASDAQ Global Market under
the symbol PSBC. Prior to July 12, 2005, trading information regarding the
common stock was available via the OTC Bulletin Board. The following table,
which summarizes trading activity during the Company’s last two fiscal years, is
based on information provided by Yahoo.com Historical Quotes.  The
quotations reflect the price that would be received by the seller without retail
mark-up, mark-down or commissions and may not have represented actual
transactions.





Table
      48: Quarterly Sales Prices
            
            Sales
      PricesQuarter Ended:
            
            High
            
            
            Low
            
            
            VolumeDecember
      31,
      2008
            
            $
            6.10
            
            
            $
            1.90
            
            
            
            209,500September
      30,
      2008
            
            
            9.70
            
            
            
            5.01
            
            
            
            208,300June
      30,
      2008
            
            
            12.43
            
            
            
            8.00
            
            
            
            106,000March
      31,
      2008
            
            
            14.80
            
            
            
            10.86
            
            
            
            111,600December
      31,
      2007
            
            
            18.89
            
            
            
            12.44
            
            
            
            132,100September
      30,
      2007
            
            
            20.74
            
            
            
            15.51
            
            
            
            310,600June
      30,
      2007
            
            
            21.90
            
            
            
            16.75
            
            
            
            149,300March
      31,
      2007
            
            $
            24.23
            
            
            $
            19.87
            
            
            
            503,000





As of
March 15, 2009, there were approximately 280 holders of record of the common
stock of the Company.





DIVIDENDS


The
Company’s primary source of cash is dividends from the Bank.  The
Bank’s ability to pay dividends is subject to certain regulatory
requirements.  The California Financial Code restricts the total
dividend payment of any bank in any calendar year to the lesser of (1) the
bank’s retained earnings or (2) the bank’s net income for its last three fiscal
years, less distributions made to shareholders’ during the same three-year
period.  As of December 31, 2008, the Bank had $4.7 million in
retained earnings available for dividends to the Company. In addition, the
Company’s ability to pay dividends to its shareholders is subject to certain
covenants contained in the indentures related to the trust preferred securities
issued by the Trusts.


The power of the Board of Directors of
an insured depository institution to declare a cash dividend or other
distribution with respect to capital is subject to statutory and regulatory
restrictions which limit the amount available for such distribution depending
upon the earnings, financial condition and cash needs of the institution, as
well as general business conditions.


-51-


Stock
Performance Graph





The
following chart, compare the yearly percentage changes in cumulative shareholder
return on our common stock during the five fiscal years ended December 31, 2008,
with (i) the Total Return Index for the Nasdaq Stock Market (U.S. Companies)
(ii) the Standard and Poor’s 500 and (iii) the Total Return Index for the Nasdaq
Bank Stocks, as reported by the Center for Research in Securities
Prices.  The comparison assumes $100.00 was invested on December 31,
2003, in our common stock and the comparison indices, and assumes the
reinvestment of all cash dividends prior to any tax effect and retention of all
stock dividends.  Price information from December 31, 2003 to December
31, 2008, was obtained by using Nasdaq closing prices as of the last trading day
of each year.








Period
      EndingIndex
            
            12/31/2003
            
            
            12/31/2004
            
            
            12/31/2005
            
            
            12/31/2006
            
            
            12/31/2007
            
            
            12/31/2008Pacific
      State Bancorp
            
            $
            100.00
            
            
            $
            254.03
            
            
            $
            229.24
            
            
            $
            269.39
            
            
            $
            155.76
            
            
            $
            23.54Nasdaq
      Bank Stocks
            
            $
            100.00
            
            
            $
            110.99
            
            
            $
            106.18
            
            
            $
            117.87
            
            
            $
            91.85
            
            
            $
            8.11Nasdaq
      U.S.
            
            $
            100.00
            
            
            $
            108.59
            
            
            $
            110.08
            
            
            $
            120.56
            
            
            $
            132.39
            
            
            $
            78.72S&P
      500
            
            $
            100.00
            
            
            $
            108.99
            
            
            $
            112.26
            
            
            $
            127.55
            
            
            $
            132.06
            
            
            $
            81.23




-52-